Contents
What’s it: Return on common equity (ROCE) is a profitability ratio for measuring the return to common stockholders on their invested capital. It is an alternative to return on equity (ROE) by isolating returns to preferred shareholders.
Like ROE, higher ROCE is better. This is because companies make higher returns relative to every dollar invested by common stockholders.
Why is the return on common equity important?
Return on common equity (ROE) measures what percentage is received by common stockholders for each net profit recorded by the company. We then compare net profit to how much they initially invested.
Return on equity (ROCE) is an alternative to return on equity (ROE). Conceptually both are the same. However, common stockholders pay more attention to ROCE than ROE.
ROCE provides a more reasonable measure of what returns are available to them. Not all net income is available to them. In addition to being retained as retained earnings, the company also distributes a certain percentage of net income as dividends to preferred shareholders. The remainder is then distributed to common stockholders.
And, preferred stockholders have a prior right to net income before distributing it to common stockholders. Or in other words, when distributing dividends, preferred stockholders have the first priority to receive it before being distributed to common stockholders.
Common stock investors use ROCE to evaluate how well a company has used their money to generate profits. They expect the company to use it effectively and efficiently to generate maximum revenue at a minimal cost. For example, companies use it to invest in key projects to support future revenue growth and, at the same time, manage them efficiently.
Finally, investors use ROCE to assess how likely and large the company will pay dividends in the future. They may expect the company to distribute regular and large dividends when it generates a high and stable ROCE over time.
How to calculate and interpret the return on common equity?
We need some manual calculations to get ROCE. First, we subtract net income (also called net profit) by dividends distributed to preferred shareholders. It shows how much is available to common stockholders. We then use it as the numerator.
Second, we subtract total equity by preferred equity, capital contributed by common stockholders. We then use the result as the denominator and show how much capital the common stockholders invest.
- ROCE = (Net profit – Preferred dividend) / Total common equity
- ROCE = (Net profit – Preferred dividend) / (Total equity – Total preferred equity)
ROCE is expressed as a percentage. The higher the percentage, the more favorable it is and the higher the return available to common stockholders. On the other hand, the lower the percentage, the less is available to them.
Reasons for higher or lower ROCE
The ideal ratio generally varies between industries. So, to make a reasonable comparison, we compare a company’s ROCE with the average of competitors in its industry. It can give us insight into how well the company generates returns to its common stockholders relative to competitors.
Then, ROCE can vary due to differences in the company’s funding strategy. For example, some companies may rely on debt to generate more profit, others may depend on equity. Taking on debt can increase ROE when it generates extra higher returns than the additional cost of capital incurred due to the debt.
Other factors affecting ROCE are competitive strategy and operations management. For example, under a differentiation strategy, a company generates high-profit margins by selling its products at a premium price. If, at the same time, the company can manage operating costs efficiently, it can lead to higher net profit.
Finally, one approach to analyzing ROCE more deeply is to use DuPont decomposition. It actually applies more to ROE, but we can also apply it to ROCE because they are, essentially, two different sides for the same coin.
Long story short, high ROCE can come from:
- Higher net profit margin. The company generates revenue at lower costs. In other words, the company generates revenue more efficiently.
- Higher asset turnover. The company managed to leverage its assets to get more revenue. The impact on net income will be even greater if, at the same time, the company manages costs more efficiently.
- Higher leverage. Companies take on more debt than equity to make a profit. Thus, it makes the total equity relatively small and makes the denominator in calculating ROCE lower.
Leverage effect
As explained earlier, one way to increase ROCE is to take on more debt. However, this approach carries risks.
ROCE increases if the additional costs of new debt generate more profit at a higher percentage. Thus, the company will unlikely have problems paying interest.
For example, when taking on debt rather than equity, the company’s assets and liabilities grow. On the other hand, equity is getting smaller. Because we use a lower denominator, we get a higher ROCE.
In another example, a company takes on debt to buy back its outstanding shares. That results in smaller total equity. As a result, ROCE increases even when the company’s net income does not change.
However, if taking on debt leads to the opposite consequence, it weighs on the company’s finances in the future. The greater the debt taken, the greater the interest expense, the greater the chance of default.
The high-interest expense increases the company’s financial risk because it has to pay it regularly, even when it cannot generate income. In addition, when debt accumulates, the company may find it difficult to obtain new debt at a cheaper cost. Creditors see the company as having a higher default risk, so they ask for higher interest to compensate for this risk. Finally, high debt limits the opportunity to grow the business through new debt.
