Understanding Return on Common Equity

Previously we introduced a profitability ratio known as return on invested capital (ROIC). This ratio measures the amount of operating profit per dollar of total capital employed in the firm. But equity investors are often interested in the earnings generated on shareholder capital only. For this, we use a measure called return on common equity (ROCE).

Calculating Return on Common Equity

When calculating ROIC, we use in the numerator a measure called net operating profits after taxes (NOPAT). Recall that NOPAT is the firm’s operating earnings, adjusted for nonrecurring items, minus taxes. Because we exclude interest expense and the associated tax deduction, NOPAT represents earnings irrespective of capital structure.

ROCE measures the earnings generated on common equity only. Therefore, we must subtract from NOPAT the amount of after-tax interest expense paid on the debt capital and any preferred dividends (if applicable). We refer to this amount as net income from operations (NIO):

Net income from operations = NOPAT – after-tax interest expense – preferred dividends

For the denominator, we use the average of the common equity over the period. We must make sure to remove any non-operating assets from the balance sheet before calculating shareholders’ equity.

Average common equity = (common equity beg. of period + common equity end of period) ÷ 2

ROCE = NIO ÷ Average Common Equity

Disaggregating Return on Common Equity Using the Dupont Formula

The DuPont formula, so named because it was created by an analyst at DuPont de Nemours, Inc., disaggregates the drivers of ROCE. This formula states ROCE as the product of three components, each of which can impact ROCE.

The first component of the DuPont equation is net income from operations divided by sales. This ratio shows the amount of operating profit per dollar of sales.

The next component is sales divided by average total assets. This ratio shows the dollar amount of sales for every dollar of assets employed in the business. This ratio is a measure of capital efficiency – i.e., the higher the sales per dollar of assets, the greater the efficiency in utilizing assets to generate revenues.

The final component is average total assets divided by average common equity. This ratio is a measure of leverage. The greater the assets relative to equity, the greater the amount of debt in the business. The inverse of this ratio shows the amount of equity as a percentage of total assets.

The DuPont formula is:

ROCE = (NIO ÷ Sales) x (Sales ÷ Average Total Assets) x (Average Total Assets ÷ Average Common Equity)

(Of course, the common variables in the numerator and denominator will cancel, leaving us with the original ROCE formula.)

Thus, the DuPont formula shows that a firm’s ROE is a function of the firm’s profit margin, capital intensity, and financial leverage. These variables are the levers which a firm can use to increase ROCE – an increase in any of these components (holding all else equal) will increase ROCE.

The first two variables in the DuPont equation represent a disaggregation of another profitability ratio, return on assets (ROA). This ratio shows the amount of operating profit per dollar of assets the business owns.

ROA = NIO ÷ Average Total Assets = (NIO ÷ Sales) x (Sales ÷ Average Total Assets)

So, the DuPont formula can also show ROCE as a function of the firm’s return on assets and financial leverage.

ROCE = ROA x Leverage

Interpreting Return on Common Equity

Recall that common equity capital is the sum of three sources: (1) the original capital contributed from shareholders, (2) any subsequent issuance of shares, and (3) any earnings which have been retained in the business. If the company repurchases shares, as publicly traded companies often do, the equity balance will be reduced by the amount of the buyback.

It is important to recognize that ROIC represents the earnings yield on the shareholder capital injected into or retained in the business. Shareholders who purchase their shares from another investor either via the public equity markets or through a private exchange, must calculate the earnings yield based on the price they paid for their shares.

One assumption of ROCE is that if we make proper adjustments to the income statement, then NIO (the numerator) is an acceptable proxy for the residual cash flow generated by the business. A key assumption here is that depreciation is an accurate provision for the average cost of replacing existing assets and maintaining existing capacity. I won’t cover depreciation here, but we should note that if a company over or under depreciates its assets, we will have to adjust NIO accordingly.

All of that said, ROCE tells us whether equity invested in the firm is yielding a sufficient return. By sufficient, we mean the ROCE should exceed the firm’s cost of equity capital.

There are several caveats to this. First, a company could have invested in long-term projects which temporarily suppress ROCE, but which create significant long-term value. In this sense, ROCE is an imperfect measure.

Another issue relates to how the firm is generating ROCE. As stated above, the DuPont formula shows the levers which drive ROCE. One of these levers is the amount of leverage the company uses. Because high rates of leverage can enhance ROCE but also increase the chance of financial distress, ROCE driven by high leverage will be less desirable to equity investors.

Calculating Return on Common Equity With an Example

Susan is the Vice President of Finance for a chain of fitness centers. She is preparing a year-end review package for the board of directors.  As part of the presentation, Susan must calculate ROCE for the last year, including a breakdown of ROCE components using the DuPont formula. The relevant information for these calculations is as follows:

• Operating sales: $12,435,982
• Operating expenses: $8,942,387
• Interest expense: $161,833
• Tax Rate: 28%
• Total assets at beginning of the year: $7,521,564
• Total assets at the end of the year: $9,384,620
• Common equity at beginning of the year: $3,475,727
• Common equity at the end of the year: $4,435,274
• Cost of equity capital: 18%

First, Susan calculates net income from operations (NIO):

[(12,435,982 – 8,942,387) x .72] – (161,833 x .72) = 2,398,869

Next, she calculates average common equity:

(3,475,727 + 4,435,274) ÷ 2 = 3,955,501

ROCE is:

2,398,869 ÷ 3,955,501 = 61%

Recall that the DuPont formula disaggregates ROCE into the following components:

Profit margin = (NIO ÷ Sales)

Capital Intensity = (Sales ÷ Average Total Assets)

Leverage = (Average total assets ÷ Average common equity)

To calculate capital intensity and leverage, Susan will need to calculate average total assets:

(7,521,564 + 9,384,620) ÷ 2 = 8,453,092

Susan can now calculate the components of the DuPont formula as follows:

Profit margin = 2,398,869 ÷ 12,435,982 = .19 = 19%

Capital intensity = 12,435,982 ÷ 8,453,092 = 1.47

Leverage = 8,453,092 ÷ 3,955,501 = 2.14

ROCE = .19 x 1.47 x 2.14 = 60% (slight difference due to rounding)

Recall that the product of the first two components of the DuPont formula is the firm’s return on assets (ROA). For this firm, ROA is:

.19 x 1.47 = 28%

ROCE is significantly higher than the firm’s ROA. The leverage ratio of 2.14 implies that over half of the firm’s assets are financed with debt, which is contributing to the higher ROCE.

So, how should Susan interpret these numbers? The ROCE is substantially higher than the firm’s cost of capital of 18%, implying that the firm is creating significant value on the equity capital injected and retained in the firm. Second, the firm is financing over one-half of its assets with debt. This level of leverage more than doubles the return which would have been earned if the firm did not employ debt.

Should Susan be concerned by the company’s debt level? Not necessarily. The assets-to-equity ratio of 2.14 implies a debt level of 53% of total assets (calculated as 1 minus the inverse of the leverage ratio). Fitness centers generally have stable, albeit seasonal, cash flows and can support a higher debt level than other businesses with more volatile cash flows. In addition, it is likely that a significant portion of the firm’s financial liabilities are in the form of long-term lease obligations. The risk of these obligations will depend on the terms of the lease. In other words, the risk of the firm’s debt will lie in the contractual details of the obligations as much as in the magnitude of the debt.

Conclusion

Return on common equity (ROCE) measures the return on every dollar of equity capital invested in and retained in the business. This ratio can be an important tool for managers and investors to determine the success to which the company has employed equity capital.

Particularly, the disaggregation of ROCE using the DuPont formula can highlight the sources which are driving ROCE. The healthiest drivers of ROCE are a healthy profit margin and low level of capital per unit of sales.