ROE: Do You Use Total Equity or Common Equity?

by Chris Hamilton

An investor can calculate or use return on equity (ROE) to determine the rate of return per share he will receive compared to the average share price over a particular time frame if he purchases stock in a company. Companies with a high ROE can invest their returns into generating additional profits or pay out dividends to shareholders. ROE calculations use common equity, frequently referred to as shareholders’ equity, instead of total equity.

Definitions

Total equity refers to the value of preferred shares subtracted from the number of shares of common stock times the price per share. The sum market value of issued common stock represents the common equity that shareholders have in the company. Preferred stock owners have seniority over common shareholders, receiving a larger dividend and more rights to compensation in the event of a liquidation or bankruptcy, according to FINRA.

Calculations

Investors can calculate return on equity by dividing the net income of a corporation after it pays taxes and preferred shareholders by the common shareholders’ equity. They can find net income on a company's income statement and shareholder’s equity, simply defined as total shareholder assets minus liabilities, on the company's balance sheet. Investors can calculate ROE on a quarterly, annualized or multi-year basis to determine the value of shareholder’s equity.

Considerations

Investors do not include total equity in ROE calculations, because preferred stock frequently carries restrictions that prevent its valuation at fair market price, such as a fixed value greater or less than the market value of a common share. In addition, preferred stock does not correlate with returns in common stock and makes up only a small percentage of the shares of most companies due to the fact that corporations cannot deduct preferred dividends, according to Standard and Poor’s.

Exceptions

When deciding whether to invest in a company with excessive preferred shares, investors can calculate ROE as net income plus preferred dividends divided by common shareholder’s equity, a calculation that will give them an idea of how much preferred shareholders have taken from common equity. They can use a formula called the DuPont formula to break down ROE calculations into three components multiplied together, including net income divided by sales, sales divided by total assets and total assets divided by common equity, according to Russell Investment Group. Investors can use the last section of this formula to compare the ratio of total assets to common equity over time, with a declining ratio potentially indicating an increased payout to preferred shareholders.

About the Author

Chris Hamilton has been a writer since 2005, specializing in business and legal topics. He contributes to various websites and holds a Bachelor of Science in biology from Virginia Tech.