Return on common equity

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Return on common equity
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Return on Common Shareholder's Equity measures the return to common shareholders which takes into account subtracting from revenues operating expenses (i.e. cost of selling, goods and administration expenses, and also income taxes), and also the cost of financing debt and preferred stock (that are senior to the common stock). Thanks to that, ROCE, takes into account the result of the companys's financing, operating and investing decisions [1].

What is Shareholders’ Equity?

Shareholders’ equity represents the capital which is initially paid into the business during buying shares (share capital) by shareholder or the retained profits/earnings of the business that the shareholder have accept, should be kept in the business. It is the permanent capital of the enterprise, it will not be repaid (unlike loans the be repaid to creditors), unless the company ceases its activities at all [2].

What does the Return on Common Shareholders' Equity consist of?

This section of a balance sheet usually consist of the following three elements[3][4][5]:

  • Contributed Capital, i.e. the cash (and also other assets) that shareholders have given a company in exchange for stock,
  • Retained Earnings - relation between company's income statement and its balance sheet. It is the sum of the net income, remaining after payment of dividends to shareholders of the company. There are two possibilities regarding generated earnings- they can be positive (profits) or negative (losses).
  • Treasury stock – according to C. Warren, J. Reeve, J. Duchac it is “a stock that corporation has issued and then reacquired”. This could be due to the willingness to support the market price of the shares.

How to calculate Return on Common Shareholdres' Equity?

The formula is\[ROCE = \frac{Net Income – Preferred Dividends}{Average Common Shareholders' Equity}\cdot100 \]

Example

Mr. X is a common stockholder in the Company XYZ. He would like to calculate the ROCE equation to compare the company with other companies in the industry. Mr. X knows that the company has distributed $250,000 in preferred dividends and that the company's reported net income is $800,000.

What is more, at the beginning of 2017, the companys's common equity was $2,300,000, whereas at the end of 2017 it grew to $2,550,000. Therefore, the average common equity for 2017 is ($2,300,000 + $2,550,000) / 2 = $2,425,000. Mr. X can calculate the firm's ROCE as follows:

ROCE = [(Net income – preferred dividends) / average common equity] x 100

ROCE = [($800,000 – $250,000) / $2,425,000] x 100 = 22.7%

Mr. X calculates that for each dollar invested, the Company XYZ returns 22.7% of its net income to the common stockholders. Compared to the industry average of 21.94%, the Company XYZ is a safe place for investing.

Footnotes

  1. J. Wahlen, S. Baginski, M. Bradshaw, 2010, p. 295
  2. P. Stimpson, A. Farquharson, 2014, p. 451
  3. B. Needles, M. Powers, 2010, p. 497
  4. B. Needles, M. Powers, 2010, p. 216
  5. C. Warren, J. Reeve, J. Duchac, 2008, p. 495 - 496

References

  • Dann L. (1981), Common stock repurchases: An analysis of returns to bondholders and stockholders, "Journal of Financial Economics", No. 9.2, p. 113-138.
  • Fama E., French K. (2006), Profitability, investment and average returns., "Journal of financial economics", No. 82.3, p. 491-518
  • Needles B., Powers M. (2010)., Financial Accounting, Cengage Learning, Mason, p. 497
  • Nikolai L., Bazley J., Jefferson J. (2010)., Intermediate Accounting, Eleventh Edition, Cengage Learning, Mason, p. 278-284
  • Shleifer A., Vishny R. (1986), Large shareholders and corporate control, "Journal of political economy", No. 94.3, p. 461-488
  • Stimpson P., Farquharson A. (2014)., Cambridge International AS and A Level Business Coursebook, Third Edition, Cambridge University Press, Cambridge, p. 451
  • Wahlen J., Baginski S., Bradshaw M. (2010)., Financial Reporting, Financial Statement Analysis and Valuation: A Strategic Perspective, Cengage Learning, Mason, p. 295-303
  • Warren C., Reeve J., Duchac J. (2008)., Financial & Managerial Accounting, Cengage Learning, Mason, p. 495-502

Author: Katarzyna Skrzyniarz