What is the difference between return on equity and return on capital?

By Ken Clark AAA
A:

Return on equity (ROE) and return on capital (ROC) measure very similar concepts, but with a slight difference in the underlying formulas. Both measures are used to decipher the profitability of a company based on the money it had to work with.

Return on equity measures a company's profit as a percentage of the combined total worth of all ownership interests in the company. For example, if a company's profit equals $2 million for a period, and the total value of the shareholders' equity interests in the company equals $100 million, the return on equity would equal 2% ($2 million divided by $100 million).

Return on capital essentially is the same formula as return on equity, but with the addition of one component. Return on capital, in addition to using the value of ownership interests in a company, also includes the total value of debts owed by the company in the form of loans and bonds.

For example, if the company in the first example also owed $100 million in debts, the return on capital would drop to 1% ($2 million divided by the sum of $100 million in equity and $100 million in debts).

Both measures are well-known and trusted benchmarks used by investors and institutions to decide between competing investment options. All other things being equal, most seasoned investors would choose to invest in a company with a higher ROE and ROC.

For more on this topic, read Looking Deeper into Capital Allocation and Keep Your Eyes on the ROE.

This question was answered by Ken Clark

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