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 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.