The rate of return on common stock equity indicates how well a company uses investment capital from its shareholders to generate revenue. A high rate of return on common stock illustrates that a company is effectively using investments made by its common stockholders. A company must compare its rate of return on common stock to other businesses in the same industry to get an accurate assessment of its financial health. The rate of return on common stock is calculated by dividing a company’s net income by the average common stockholders’ equity.
Locate net income on an income statement. Net income indicates the profit generated by a business during a 12-month period. A company’s net income illustrates the profit a company makes after expenses, losses and income taxes. Net income gets transferred to the stockholders’ equity section of the balance sheet. A company will either reinvest net income in the form of retained earnings, or distribute them to shareholders in the form of dividends.
Observe the stockholders’ equity section of the balance sheet. Assume a company has not issued any preferred shares. This means all stock issued by the company is common stock. Stockholders’ equity indicates the amount of capital shareholders have invested in the business. A company can calculate stockholders’ equity by subtracting total liabilities from total assets. Compare the company’s stockholders’ equity balance at the beginning of the year to its stockholders' equity at the end of the year.
Add the beginning stockholders’ equity with the ending stockholders’ equity amount. For instance, a company with $100,000 beginning stockholders’ equity and $150,000 ending stockholders’ equity has stockholders’ equity of $250,000. Divide $250,000 by two to determine the average stockholders’ equity. In this case, average common stockholders’ equity is $125,000.
Divide net income by average common stockholders’ equity. Assume a company has net income of $40,000 and average common stockholders’ equity of $125,000. In this scenario, a company’s rate of return on common stock equity equals .32 or 32 percent.
Items you will need
- Balance Sheet
- Income Statement