The return on common equity ratio reveals the amount of net profits that could potentially be payable to common stockholders. The measurement is used by shareholders to evaluate the amount of dividends that they could potentially receive from a business.
The return on common equity calculation can also be used as a simple measure of how well management is generating a return, given the current amount of equity on hand.
The ROCE metric is not a good one, for the following reasons:
- The amount of profit reported does not necessarily coincide with the amount of cash on hand that would be used to pay dividends. Thus, a company reporting a large profit may have no cash with which to pay dividends. This situation is especially common when a business uses the accrual basis of accounting.
- There is not necessarily any relationship between the amount of dividends paid and the earnings of a business in any given period. Instead, the board of directors (which authorizes dividends) likes to achieve consistency in the amount of dividends paid from period to period, which means that dividend payments tend to be more stable than earnings.
- If a business has a large amount of debt payments, there may be few funds available for the payment of dividends to the holders of common stock.
- Management could be funding operations with debt, rather than equity. Doing so increases the return on common equity, but risks bankruptcy if management cannot pay off the debts in a timely manner.
A better use of the measurement is to couple it with an analysis of where a company is in its life cycle. A mature business with a high ROCE is more likely to have enough cash on hand to pay dividends. Conversely, a rapidly-growing business with a high ROCE may have so little cash that it cannot possibly pay any dividends.
The return on common equity is calculated as:
(Net profits - Dividends on preferred stock) ÷ (Equity - Preferred stock)
This calculation is designed to strip away the effects of preferred stock from both the numerator and denominator, leaving only the residual effects of net income and common equity.
If a business has no preferred stock, then its calculations for the return on common equity and the return on equity are identical.