Definition: The return on common stockholders’ equity ratio is the proportion of a firm’s net income that is payable to the common stockholders.
What Does Return on Common Shareholders’ Equity Mean?
What is the definition of ROCE? ROCE indicates the proportion of the net income that a firm generates by each dollar of common equity invested. Firms with a higher return on equity are more efficient in generating cash flows. Generally, investors have greater confidence in companies with a high and sustainable ROCE than in growth-oriented companies that cannot sustain growing returns on common equity.
ROCE is compared to the industry average to assess a company’s operating performance, and it is different than the return on equity (ROE) which measures the return on a firm’s total equity, i.e. on both the preferred equity and common equity.
The return on common equity formula is calculated using the following: the net income, the preferred dividends, and the average common equity.
Let’s look at an example.
Anastasia is a common stockholder in the Company ABC. She wants to calculate the ROCE equation to compare the firm with the industry. Anastasia knows that the company has distributed $200,000 in preferred dividends and that the firm’s reported net income is $850,000.
Furthermore, in the beginning of 2015, the firm’s common equity was $2,000,000, whereas at the end of 2015 it grew to $2,450,000. Therefore, the average common equity for 2015 is ($2,000,000 + $2,450,000) / 2 = $2,225,000. Anastasia can calculate the firm’s ROCE as follows:
ROCE = ((Net income – preferred dividends) / (average common equity)) x 100 = (($850,000 – $200,000) / $2,225,000) x 100 = 29.2%.
Anastasia finds out that for each dollar invested, the company ABC returns 29.2% of its net income to the common stockholders. Compared to the industry average of 22.4%, the company ABC is a safe bet for investing.
Define Return on Common Stockholder’s Equity: This is the percentage of net income that the common shareholders get to keep in return for owning their shares.