Return on Common Equity (ROCE) is a vital measure of a company's investment profitability. Unlinke, Return on Capital Employed, it focuses specifically on common equity. In this article, we'll delve into the definition and calculation of ROCE, provide practical examples, explore its limitations, compare it to other financial metrics, and offer a conclusive perspective. But first:
What is Return on Common Equity (ROCE)?
ROCE is a percentage ratio calculated by dividing the company's net income by the common equity, excluding retained earnings, and multiplying the result by 100%.
Image source: Corporate Finance Institute
This ratio provides valuable insights into the potential profitability of funds invested in a company. A high ROCE signals an enticing investment opportunity, whereas a low one should prompt caution among potential investors.
ROCE is particularly effective when comparing companies within the same industry. Due to variations in average ROCE ratios across industries, it is less suitable for cross-sector comparisons. Furthermore, ROCE serves as a tool for evaluating a company's performance over time, shedding light on whether its financial health is on an upward trajectory or in decline. Even a company with a strong financial history but a deteriorating trend may not be an attractive investment.
Calculating Return on Common Equity
To compute ROCE, you'll need the following figures:
Company's Net Income (NI)
Preferred Dividends (PD)
Average Common Equity (ACE)
The ROCE formula is as follows:
Examples of Return on Common Equity
Let's illustrate ROCE with a scenario: Henry owns shares in a company named Ex. He aims to evaluate Ex's performance relative to industry peers. Ex reported a net income of $2 million and distributed $800,000 as preferred dividends in 2022. The average common equity for Ex during the year was $10 million.
Net income = $2,000,000
Preferred dividends = $800,000
Average common equity = $10,000,000
Henry can compute Ex's ROCE as:
((2,000,000 – 800,000) / 10,000,000) x 100 = 16%
Ex's ROCE of 16% indicates that for every dollar invested, a return of 16% can be expected from the company's net income. If the industry average stands at 20%, Henry might reconsider his investment in Ex in search of better opportunities.
Limitations of ROCE
ROCE is not a flawless measure of company profitability. Here are scenarios where relying solely on ROCE might be misleading:
1. Mismatched Profit and Dividends: Reported profit may not match the actual cash available for dividends. This mismatch can result in delayed or incomplete dividend payments, particularly for companies using accrual accounting methods, which can be riskier in this context.
2. Debt Hindrance: High debt obligations can hinder a company's ability to pay dividends, even though there is no legal requirement to distribute dividends to common equity shareholders. Excessive debt can impede timely dividend disbursements.
3. Board Decisions: Dividend amounts are determined by boards of directors and may not always align with the company's actual profits. Consistent dividends can be paid irrespective of profitability.
4. Insolvency Risk: Companies relying on debt rather than common equity to fund dividends face the risk of insolvency. If the company goes bankrupt, the prospect of receiving future dividends becomes uncertain.
All these situations highlight the importance of not solely relying on ROCE and reported profits to gauge a company's financial health. Dividends are influenced by factors beyond profitability, emphasizing the need for a more comprehensive assessment.
ROCE vs Other Financial Metrics
In this section, we will compare ROCE to other financial metrics to uncover its strengths and limitations. This comparison underscores how different metrics can complement one another to enhance the accuracy of profitability assessments.
Return on Assets (ROA): ROA sheds light on a company's profit generation from its assets. Unlike ROCE, which focuses on common equity, ROA considers the entire asset base, including debt. It's important to note that ROA doesn't necessarily increase with rising debt levels. When ROCE significantly outpaces ROA, it suggests the company may be heavily reliant on borrowed assets, potentially indicating higher investment risk.
Return on Investment (ROI): ROI measures the profit generated by a specific asset or project within the company, rather than the entire equity. If you're evaluating an investment in a particular asset within a complex corporate structure, ROI can be a more fitting metric.
Earnings per Share (EPS): EPS provides a straightforward metric, revealing the company's net income per share. This metric can complement more general ones like ROA or ROCE, offering a focused perspective on shareholder earnings.
Price-to-Earnings (P/E) Ratio: The P/E ratio assesses the relationship between a company's stock price and its earnings per share. When used alongside broader metrics, the P/E ratio enhances the precision of profitability evaluations.
In conclusion, ROCE isolates common equity for profitability evaluation but isn't foolproof due to potential information gaps. It's advisable to complement ROCE with other metrics for a well-rounded analysis.
How can companies improve their return on common equity?
Companies can enhance ROCE by leveraging financial resources, increasing revenue, reducing expenses and optimizing tax strategies.
Should I use ROE or ROCE?
Choose between ROE and ROCE based on your objectives. ROE offers a broader perspective, while ROCE is ideal for companies relying heavily on borrowed assets. ROE is versatile and suitable for evaluating any profit-generating firm.