Return on common equity
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].
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].
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.
The formula is:
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.
Examples of Return on common equity
- Return on Common Equity (ROCE) is a measure of how much profit a company can generate from its shareholders' investments. It is calculated by taking the company's net income and dividing it by the common equity on the company's balance sheet. This provides an indication of how efficiently a company is using the money invested by its shareholders and how much return they are getting on their investment.
- This measure is also used to compare the performance of one company to another as it takes into account the financial structure of the business. A higher ROCE indicates that the company is generating more profit with the same amount of equity, while a lower ROCE indicates that the company is using more equity to generate the same level of profits.
- Return on Common Equity can also be used to compare the performance of one company to an industry average. If a company's ROCE is greater than the industry average, it indicates that the company is more efficient at generating profits than its peers.
Advantages of Return on common equity
Return on Common Shareholders Equity (ROCE) is a metric used to measure a company’s profitability and efficiency. It is an important indicator for investors as it reflects how well management is utilizing the company’s resources to generate returns for its common shareholders. The advantages of ROCE include:
- ROCE is a very useful metric for comparing companies because it takes into account the company’s debt obligations, making it a more accurate measure of profitability than other metrics.
- It also allows investors to compare companies in different industries as it is not affected by differences in capital structure.
- ROCE is also easy to calculate and understand, making it a great tool for investors to make informed decisions on potential investments.
- Finally, ROCE is an excellent indicator of a company’s ability to generate returns for its common shareholders and is a key metric for assessing management’s performance.
Limitations of Return on common equity
- Return on Common Shareholders Equity does not reflect the risk associated with a particular business. It does not take into account the amount of leverage used by the company or the quality of the assets that support the debt.
- It does not measure the effect of changes in the price of assets held by the company, or the cash flow from investments made by the company.
- It does not take into account how much the company pays its common shareholders in dividends, or how much it pays for financing the company’s operations.
- It does not take into account the value of the company’s intangible assets, such as its brand recognition, customer loyalty or patents.
- It does not reflect the cost of capital, which includes the cost of debt and equity, or the cost of acquiring new capital.
To measure the return to common shareholders, there are other approaches to consider in addition to Return on Common Shareholders Equity. These include:
- Return on Assets - This measures the return on all investments, including debt and equity, which can be used to compare the efficiency of different companies.
- Return on Equity - This measures the return for common shareholders using total equity (i.e. common equity plus preferred equity).
- Earnings Per Share - This measure the return to common shareholders by dividing the net income by the number of shares outstanding.
- Price to Earnings Ratio - This measures the return to common shareholders by dividing the stock price by the earnings per share.
In summary, Return on Common Shareholders Equity is one approach to measure the return to common shareholders, but there are other options to consider, such as Return on Assets, Return on Equity, Earnings Per Share, and Price to Earnings Ratio.
Footnotes
| Return on common equity — recommended articles |
| Market value ratios — Free cash flow yield — Degree of financial leverage — Earnings per share — Market value added — Ebitda ratio — Termination cash flow — Unlevered free cash flow — Capitalization ratios |
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
