So you’ve found a new firm that’s piqued your interest? You are still not sure, though, whether or not this firm can actually make your investing dreams come true. While firms might lie to the moon and back to prove their financial health to you, numbers don’t. One of the most important numbers you need to consider for a new stock market investment is the return on common stockholders equity (ROCE).
In simple words, the number represents the bang you’re getting for your buck. But of course, there are certain delicacies you need to beware of, which brings us here and today.
Find out the return on common stockholders equity formula and learn how you can use this ratio to enhance the profitability of your investments.
What Is Return on Common Stockholders Equity?
In simple words, the return on common stockholder’s equity shows you how much you’re profiting as a common investor in a firm. The ROCE rate shows how much money you make for every dollar you invest in a firm as a common investor.
ROCE can be a ratio or a percentage. Either way, you can look at the ROCE rate of different companies to get a feel of their financial health. So, for example, a 10% (0.10) rate shows that you’re earning 10 cents for every dollar you initially poured into the company.
Although there are also other factors to consider, the rate of return on common stockholders equity can help you determine how companies in the same sector are performing in comparison to one another and which ones are worth your consideration.
Return on Common Equity (ROCE) vs Return on Equity (ROE)
Another term you might hear a lot when it comes to the investigation of different firms from an investor’s point of view is return on equity (ROE). It’s a similar concept to ROCE, but there are still minor differences.
To help you grasp the subject fully, we need to take a step back. Common and preferred equity are two types of stocks offered by public firms. Common shareholders hold ownership of the company, participate in decision making activities, receive their dividends last, and share the company’s gains and losses.
Preferred shareholders also hold ownership of the company, but they can’t vote or make decisions. At the same time, they receive a prespecified amount of money as their dividend each month.
When we speak about return on common stockholders’ equity formula and its difference with ROE, the main difference is the return on preferred stocks. Namely, these shares are not considered in ROCE calculation, rather in ROE.
What Is the Return on Common Stockholders Equity Formula?
To calculate the return on common stockholders’ equity ratio, follow the formula below:
In the formula above, net income refers to the earnings of the company in period t, minus taxes and other expenses. It deducts taxes and interest from the company’s annual revenue.
At the same time, the average common equity is calculated by adding the common equity at the beginning of period t to the same metric at the end of the period and dividing the sum by 2.
The reason we use average common equity and not just common equity is because both the ROCE and net income measure the company’s performance over a period of time. This is while common equity is usually a flat number that represents a single time period.
You can find the company’s net income in its income statement, which sums up the company’s financial activity over a specified period. As for common equity data, you can find that on the firm’s balance sheets, which keeps tabs on the company’s historical changes in assets and liabilities.
Advantages of Return on Common Equity
When you become a shareholder at a company, you’re basically lending them your money to do what they see fit. In the midst of all the uncertainties of this concept, having access to the rate of return on common equity could help you in several ways.
First and foremost, ROCE can help you gauge the efficiency of different firms, which is great for risk management. Those with higher return on common equity ratios are likely to have a strong management system, while companies with lower ROCE ratios might suffer from inefficient management.
On the other hand, ROCE makes it easier for investors to compare different firms in the same field. For example, let’s say you’re interested in investing in tech. You’ve narrowed down your options to companies A and B. Company A has a return on common equity of 35%, while Company B’s ROCE is set at 20%. In such a case, it’s usually thought that company A might be a more appealing option.
Lastly, you can track company growth by using ROCE as a means of YoY analysis. Particularly, consistent rations over time could be a sign of stability, whereas increasing ROCE can suggest growth.
Limitations of Return on Common Stockholders Equity
Despite its advantages, ROCE is not perfect either. For example, the rate of return on common equity might fail to represent the company’s debt levels, leading to an increased ratio that is not necessarily a better investment.
Since equity is calculated by deducting debts from assets, a company might borrow excessively to inflate its ROCE. You need to be aware of such dangers as an investor.
This debt distortion is a great example of how ROCE might be a single-dimensional metric. As a result, you also need to consider other factors like Return on Assets (ROA) and Earnings Per Share (EPS).
Another shortcoming of ROCE is its inability to compare firms across various industries. For example, tech companies tend to have higher ROCE ratios compared to those of utility firms. Still, this difference doesn’t automatically make tech firms a better investment opportunity compared to energy trading.
Example of Rate of Return on Common Stockholders Equity Formula
Let’s say you’re analyzing a fictional company, GreenTech Inc. Here are the details from their financial statements:
- Net Income: $500,000
- Preferred Dividends: $50,000
- Beginning Equity: $2,000,000
- Ending Equity: $2,500,000
First, calculate the average equity:
($2,000,000 + $2,500,000) / 2 = $2,250,000
Next, subtract the preferred dividends from the net income:
$500,000 − $50,000 = $450,000
Finally, divide the adjusted net income by the average equity:
ROCE=$450,000 / $2,250,000 = 0.20 or 20%
GreenTech’s ROE is 20%, meaning that for every dollar of equity invested, it generates 20 cents in profit. That’s a solid performance!
Now, let’s consider that you’re also interested in another company called SolarFuture, with a ROCE ratio of 30%. Should you just go ahead and invest in it then? After all, it’s got higher rates.
The simple answer to this question is a big no. While SolarFuture has a higher rate of common equity, it also has a higher debt-to-equity ratio, which could single-handedly inflate the company’s ROCE.
At the same time GreenTech has managed to consistently get a ROCE ratio of 20% for the past 5 years, whereas SolarFuture’s numbers have fluctuated dramatically over time.
Considering these extra pieces of information, GreenTech secures an obvious advantage for itself, becoming the ideal investment opportunity.
What Is a Good Return on Common Stockholders Equity Ratio?
Simply put, there’s no one-size-fits-all best ROCE ratio you can look for in a market. It’s mostly up to the industry or sector in which the company conducts its activities. For example, tech companies tend to have higher ROCE ratios (20%-30%), whereas utility firms average around 8%-12%.
A general rule of thumb would be to look for double-digit return on common equity ratios. However, the closer this number is to the long-term average of the S&P500, the better.
Wrap-Up
Return on common equity ratio is a measure of investment profitability for common shareholders. It helps investors compare firms, gauge their performances, and track their growths. At the same time, it should always be considered in industry context and alongside other metrics.
The rate of return on common stockholders’ equity formula divides the net income of the company in a set period of time (usually a financial year) to the average common equity of the firm.
The ROCE and its formula are just a small part of the ever-evolving, gigantic stock market today. If you want to succeed in this competitive environment, you need to get to work now! Follow our weblog to access the simplest, most comprehensive educational material you could ask for, and open a demo account to test and refine your strategies.
Return on common stockholder equity (ROCE) refers to a company's profitability in relation to each unit of common equity it has. In other words, it tells common investors how much money they earned for every dollar of their investment.
To calculate the return on common stockholders equity ratio, you need to divide the company's net income by the average common equity of the firm between the start and end of the evaluated time period.
Generally, investors should look for return on common equity ratios above 10%. The closer this number is to the long-run average of the S&P500, the more profitable the investment potentially becomes..
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