How to Calculate Rate of Return on Common Stockholders’ Equity

The Rate of Return on Common Stockholders’ Equity (ROCE) serves as a financial metric that indicates how effectively a company uses the investments made by its common shareholders to generate profits. It specifically measures the profit a company generates for each dollar of equity contributed by its common shareholders. This article will detail the step-by-step process to calculate this financial ratio.

Understanding Adjusted Net Income

The numerator for the Rate of Return on Common Stockholders’ Equity calculation is net income. Net income represents a company’s total earnings, found at the conclusion of the income statement. This figure reflects all revenues minus expenses, including taxes, over a specific reporting period, typically a quarter or a year.

If a company has issued preferred stock, preferred dividends must be subtracted from the reported net income to arrive at the income available solely to common shareholders. Preferred dividends are payments made to preferred stockholders, which hold a higher claim on a company’s earnings than common stock dividends. These payments are typically fixed and must be paid before any dividends can be distributed to common shareholders.

Subtracting preferred dividends is necessary because the Rate of Return on Common Stockholders’ Equity measures the return generated for common shareholders only. Information regarding preferred dividends can be found on the income statement, statement of cash flows, or in the footnotes accompanying the financial statements. This adjustment ensures the profit figure accurately reflects what is available to common equity holders.

Understanding Common Stockholders’ Equity

The denominator for the Rate of Return on Common Stockholders’ Equity calculation is common stockholders’ equity. This represents the residual value of a company’s assets after all liabilities and preferred equity claims have been satisfied. Common stockholders’ equity signifies the portion of the company’s net assets that belongs directly to its common shareholders.

Total stockholders’ equity is located in the equity section of a company’s balance sheet. If a company has preferred stock, its value must be subtracted from the total stockholders’ equity to isolate the common stockholders’ equity. This value is generally based on the preferred stock’s par value or its liquidation preference.

To match the income statement’s period, use the average common stockholders’ equity over that same period. Using an average accounts for any changes in equity that occurred during the year, providing a more representative figure. This average is calculated by summing the common stockholders’ equity at the beginning of the period and the common stockholders’ equity at the end of the period, then dividing the result by two. This approach requires accessing balance sheets from two distinct dates, such as the end of the prior and current fiscal years.

Calculating the Rate of Return

The Rate of Return on Common Stockholders’ Equity is calculated using the formula: (Net Income – Preferred Dividends) / Average Common Stockholders’ Equity. This formula applies the adjusted net income and average common stockholders’ equity figures derived from the preceding steps.

To illustrate this calculation, consider a hypothetical company. Suppose the company reported a net income of $500,000 for the fiscal year and paid $50,000 in preferred dividends. The net income attributable to common shareholders is $500,000 minus $50,000, resulting in $450,000.

Next, consider the common stockholders’ equity figures. Assume the common stockholders’ equity was $4,000,000 at the beginning of the fiscal year and $5,000,000 at the end. To find the average common stockholders’ equity, sum these two amounts ($4,000,000 + $5,000,000 = $9,000,000) and divide by two, yielding an average of $4,500,000.

With both components determined, the Rate of Return on Common Stockholders’ Equity can be calculated. Divide the adjusted net income of $450,000 by the average common stockholders’ equity of $4,500,000, which results in 0.10. To express this as a percentage, multiply the decimal by 100, yielding a Rate of Return on Common Stockholders’ Equity of 10%.