"Return on equity" provides a rough gauge of how profitable a company has been over the course of a year. Simply put, it measures what percentage of the money invested by stockholders comes back as profit. A look at the factors that go into calculating return on equity -- and its cousin, "return on common stockholders' equity" -- makes clear what can cause returns to rise or fall.
Equity vs. Common Equity
The basic formula for return on equity involves numbers drawn from the company's annual financial statements: Divide the company's net income for the year by stockholders' equity. If a company has a net income of $15 million, for example, and equity of $123 million, then return on equity would be $15 million / $123 million, or 12.2 percent. Most companies don't have preferred shares, so for them, return on equity is the same thing as the return on common stockholders' equity, or just "return on common equity." But for companies that also have preferred shares, the return on common equity formula is a bit different: Take net income, then subtract any preferred dividends, and then divide the result by the company's "common equity," which is the portion of stockholders' equity attributable to common stock.
Net Income Factors
Net income is simply a company's profit for the year, or the difference between its revenue and its expenses. The higher the profit, the higher the return on both equity and common equity. If profit declines, return on equity and return on common equity go down too. Note that an increase in revenue or a decline in expenses doesn't necessarily raise net income, and that declining revenues or rising expenses don't necessarily reduce net income. What matters is the difference between revenue and expenses.
Changes in Equity
You can define stockholders' equity two ways. One is simply as the difference in value between the company's assets and its liabilities. The other definition is the total amount of money the company has raised by selling stock to the public, plus all profits reinvested in the company over the years. These reinvested profits are called "retained earnings," and they're essentially the sum total of all years' net income, minus any dividends paid to stockholders. To figure common stockholders' equity in a company with preferred shares, take the total equity and subtract the amount the company has raised by selling preferred stock. Changes in the elements that make up stockholders' equity will affect return on both equity and common equity. For example, say a company sells $100 million worth of new common stock to the public. The company is hoping the new capital will increase future net income. But this sale of new stock makes the overall equity figures larger, which is probably going to reduce the return in at least the short term. Meanwhile, if a company writes down the value of its assets, that's going to reduce overall equity, which might boost the return.
Preferred shares are a kind of hybrid between a stock and a bond. Unlike common shares, they generally don't convey voting rights. But they come with a guaranteed dividend. If the company makes a profit -- and sometimes even if it doesn't -- the preferred shareholders will get a cash payment. Holders of common stock generally get dividends only if there's money left after paying the preferred dividend. Because the calculation for return on common equity reduces net income by the amount of any preferred dividends paid during the year, changes in the preferred dividend will affect return on common equity.
- Investopedia: Return on Equity
- "Financial Accounting for MBAs," Fourth Edition; Peter Easton et al; 2010
- AccountingCoach.com: What Is the Return on Stockholders' Equity (After Tax) Ratio?; Harold Averkamp