What is Return on Common Equity?
The Return on Common Equity (ROCE) 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 measure the total returns that the company generated on all of its equity. Capital received from investors in 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 would mean that the company is generating high profits from its equity investments, thus making the company more likely to pay out dividends.
Furthermore, the ROCE ratio can be used to evaluate how well the company’s management has utilized equity capital to generate value by running the business. A high ROCE would suggest that the company’s management is making good use of equity capital by investing in NPV-positive projects, thus creating 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 with regards to the two areas of interest.
Dividends are discretionary, meaning that a company has is not under legal obligation to pay dividends to its common equity holders. Whether a company pays out dividends or not depends on where the company is in its lifecycle. An early-stage company would likely want to reinvest its earnings into pursuing new projects or funding R&D for upcoming products. By contrast, a more mature company that is already profitable may choose to disburse its earnings into dividends to keep investors happy. Such considerations are more accurate ways of determining whether a company is likely to pay a dividend than a return on common equity.
In terms of assessing management’s use of equity capital, 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 such a 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, but rather to management’s use of company funds in general. In certain cases, management bonuses may be tied to hitting certain ROCE measures, a further incentive to find ways of avoiding issuing more equity.
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 will need to calculate ROCE; namely net income and common equity. Using the formula provided above, we arrive at the following figures:
In such a case, we can see that the return on common equity has been consistently trending up from 2015-2017 before dipping in 2018 due to a large equity issue.
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