Evaluating a company's use of common equity capital
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The Return on Common Equity (ROCE) ratio refers to the return that common equity investors receive on their investment. ROCE is different from Return on Equity (ROE) in that it isolates the return that the company sees on its common equity, rather than measuring the total returns that the company generated on all of its equity. Capital received from investors as preferred equity is excluded from this calculation, thus making the ratio more representative of common equity investor returns.
Return on Common Equity is used by some investors to assess the likelihood and size of dividends that the company may pay out in the future. A high ROCE indicates the company is generating high profits from its equity investments, thus making dividend payouts more likely.
The ROCE ratio can also be used to evaluate how well the company’s management has utilized equity capital to generate values. A high ROCE suggests that the company’s management is making good use of equity capital by investing in NPV-positive projects. This should create more value for the company’s shareholders.
How to Calculate Return on Common Equity
Return on Common Equity (ROCE) can be calculated using the equation below:
Net Income = After-tax earnings of the company for period t
Average Common Equity = (Common Equity at t-1 + Common Equity at t) / 2
As discussed above, the ratio can be used to assess future dividends and management’s use of common equity capital. However, it is not a perfect measure, since a high ROCE can be misleading.
Dividends are discretionary, meaning that a company is not under a legal obligation to pay dividends to common equity shareholders. Whether a company pays out dividends often depends on where the company is in its lifecycle. An early-stage company is likely to reinvest its earnings in growing the business, such as funding R&D for new products. A more mature company that is already profitable may choose to disburse its earnings as dividends to keep investors happy.
In terms of assessing management’s use of equity capital, analysts and investors should exercise caution in using the ROCE ratio. It is important to note that, just like ROE, ROCE can easily be overstated.
Suppose that a company chooses to pursue an NPV-positive opportunity and funds the project with debt capital. The project pays off and the company sees its net income figure rise. In this scenario, ROCE would increase by a fair margin since the amount of outstanding common equity has not changed, but net income has increased. However, the rise in net income was not due to management’s effective use of equity capital. Instead, it was simply due to management’s use of funds in general.
In some cases, management bonuses are tied to hitting certain Return on Common Equity levels. Because of that fact, management may be tempted to take actions that inflate the ratio.
Return on Common Equity Example
Ben’s Ice Cream wants to calculate the return on common equity that the business generated over the past year. Below are snippets from the company’s income statement and balance sheets:
The red boxes highlight the important information that we need to calculate ROCE: net income and common equity. Using the formula provided above, we arrive at the following figures:
The return on common equity has been consistently trending up from 2015-2017, before dipping in 2018 due to a large equity issue.
Thank you for reading this CFI article on the Return on Common Equity ratio. To learn more about related topics, check out the following CFI resources:
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