What is Return On Common Stockholders Equity (ROCE)?
Definition: Return on common stockholders (ROCE) is a metric that measures the ability of a company to return value to shareholders. It is simply the ability of a company to generate net income for the benefit of shareholders.
In its purest form, it is the proportion of a company’s net income paid to shareholders per equity invested.
ROCE Example
Return on common stockholders gives rise to a ratio that ascertains the amount of income generated for each dollar amount invested in a company. Therefore, it is computed by dividing the total net income by common shareholders’ equity. The ratio, in this case, provides valuable insight into the profit margin of any business. A higher return on common stock stockholders affirms a company’s effectiveness in the utilization of shareholders invested capital in the generation of income.
Likewise, companies that have a higher return on common stockholders equity tend to be more efficient in generating cash flows. Such companies are known to offer dividends as a way of returning value to shareholders as well as carrying out buybacks. Investors have high regard to such companies as opposed to growth-oriented companies that deploy free cash flow into new ventures.
Return on Shareholders’ equity is one of the financial metrics used to measure the amount of money returned to shareholders, the other commonly used financial metrics include net profit margin ratio as well as gross profit margin ratio and return on total assets.
ROCE Formula
The return in commons stockholders’ equity formula differs a great deal from return on equity in that it does not take into consideration the return that a company sees on its common equity. Instead, it focuses on the return made on each dollar amount invested by shareholders.
The financial metric is calculated by simply dividing the total net income generated in a given financial period with the average common equity
Consider company ABC that had a net income of $4 million for the 2019 financial year. The company also reported a preferred dividend of $100,000 and preferred equity worth $1 million. If the common equity amounted to $14.5 million, then the Return on Common Stock Equity would amount to
Return On Common Stockholders Equity Analysis Drawbacks
When it comes to making investment decisions, it is important to be extremely cautious while using the ROCE ratio. Just like most financial metrics, ROCE can be overstated. For instance, a company can decide to fund the development of a project with debt capital. Should the project payoff, the company is likely to experience an increase in net income.
However, the rise in net income cannot, in this case, be attributed to effective use of common stock holder’s equity. Instead, the net income was mostly because of management’s effective use of funds in general.
In some companies, bonuses are mostly tied to ROCE levels. A manager who is able to steer a company to higher ROCE margins tends to walk away with bumper bonuses. With that in mind, some managers are usually tempted to inflate the ration, which can be deceiving to investors.
Summary
Return on common stockholder equity indicates the proportion of net income that a business generates from the dollar amount of common equity invested. Therefore, the metric is used to ascertain the likelihood of a firm to pay dividends or carry out buybacks depending on the amount of cash flow on its balance sheet. A higher ROCE ratio indicates high profits, thus affirming the likelihood of a company to pay out dividends.
Conversely, return on common stockholder equity is used to ascertain a company’s performance over a given period as well as compare its performance within a given industry.