Return on Common Equity Ratio
This is a complete guide on how to calculate Return on Common Stockholders Equity (ROE) ratio with detailed analysis, interpretation, and example. You will learn how to utilize its formula to assess a firm's profitability.
What is Return on Equity (ROE)?
The return on common stockholders equity ratio, often known as return on equity or ROE, allows you to calculate the returns a company is able to generate from the equity that common shareholders have invested in it.
This ratio is a great tool for keeping tabs on a business you already own shares in, or for evaluating one you’re considering as an investment.
The more capable a company is of yielding a profit from equity, the higher its return on equity will be.
This ratio lets you know exactly how much in net income a firm is producing from each dollar of the equity invested by its common shareholders.
As an investor, the return on equity figure is not only important for showing you how effectively a company is using your money to generate returns, it also demonstrates how efficient the firm’s management team is at using equity to support ongoing operations, and to fund growth and expansion.
Return on Stockholders Equity Formula
When you want to calculate the return on equity for a particular company, you can use the following formula:
Return on Equity Ratio = Net Income / Total Shareholders' Equity
Since most investors are common shareholders, it’s not uncommon to see this formula adjusted to account for any profit that’s earmarked for the payment of preferred share dividends.
In this case, the amount of the preferred stock dividends for the relevant period would be subtracted from the firm’s net income (Net Income – Preferred Stock Dividends).
The shareholder equity amount used in the formula is usually averaged for the period being evaluated.
Read also: Return on Sales - Formula, Example, Analysis
Return on Common Stockholders Equity Calculator
Example - How To Calculate Average Common Stockholders Equity Ratio
Perhaps you already own shares in Company FF, and you’d like to measure its return on common stockholders' equity for the past year.
When you examine Company FF’s financial statements, you find the following information:
- Net Income = $900,000
- Preferred Stock Dividends = $100,000
- Opening Common Shareholder Equity = $800,000
- Closing Common Shareholder Equity = $1,200,000
For calculating the return on common stockholders' equity, we will:
- Adjust the Net Income by subtracting the preferred stock dividends
- Calculate the Average Common Equity by summing the opening and ending equity and then dividing the result by 2
- Plug the Adjusted Net Income and the Average Common Equity into the formula
Return On Equity Analysis
A return on equity of 1, or 100%, means that a company is effectively creating a dollar of net income from every dollar of its shareholder equity.
So what is considered a good return on equity?
A higher ratio indicates a higher level of profitability, and vice versa.
But because the expected, and therefore acceptable, result for a firm’s return on equity varies from industry to industry, you should always compare your result to that of other companies within the same sector.
The return on common stockholders' equity ratio is also a useful way to measure the historical financial performance of an individual business, over a period of time.
Cautions When Using The Return On Common Stockholders Equity Ratio
How can a company improve its return on equity?
It’s possible for a business to increase its return on equity result by decreasing the total amount of its shareholder equity.
This can be accomplished by electing to buy back some of its own shares from investors.
The ROE can also be made to appear attractively higher if a company chooses to operate using more debt, and less equity.
But both of these actions have the potential to adversely affect a firm’s financial health, especially if the company takes on additional debt in order to fund its stock buyback.
The greater a company’s debt load, the more reliant it becomes on a stable and predictable income.
Businesses in this situation are more vulnerable to the possibility of becoming unable to meet their debt obligations when sales drop off for any reason.
As an investor, it’s also important for you to remember that a higher return on equity doesn’t always translate into more money in your pocket today, since many organizations choose to retain their profits in order to fund future growth.
To gain a better understanding of a company's current operating performance, you should consider using this ratio with other profitability ratios, such as the ROA ratio and the return on capital employed ratio.