What it means
Companies can have more than one class of owner. Preference shareholders sit ahead of ordinary shareholders in the queue for profit, receiving a fixed dividend before anything is shared out, so the profit reported at the bottom of the income statement is not all available to common holders.
This ratio corrects for that by deducting preference dividends from net income and dividing by common equity alone. The distinction matters whenever a business has issued preference shares, which is common in banks, insurers, utilities and companies that raised rescue capital.
Ignoring the preference claim can overstate the return to ordinary owners quite significantly, particularly when the preference dividend is large relative to profit. For a company with no preference shares at all, this ratio is simply return on equity under a longer name.
Managers use it to judge whether the ordinary shares are earning enough to justify the risk their holders take. Ordinary shareholders rank last in every claim on the business, so they expect a return well above what lenders or preference holders receive.
If common equity is earning 6% while the company borrows at 7%, something is badly wrong with the capital structure. The calculation uses average common equity over the year rather than the closing balance whenever the share base has changed materially.
Common equity itself is total shareholders' equity minus the carrying value of preference shares, and it includes ordinary share capital, share premium and retained earnings. One nuance deserves attention: a high figure can come from genuine profitability or from a very thin equity base.
A heavily borrowed company with small common equity can post a spectacular return that reflects financial leverage rather than operating excellence, and that same leverage makes losses just as dramatic when trading turns down.
In practice
Real-world examples.
Example
A regional bank issued preference shares during a capital raise and now pays $4,000,000 a year on them. Its headline return on equity looks healthy at 11%, but the return on common equity is only 8%, which is what the ordinary shareholders actually experience.
Example
A property group with no preference shares reports a return on common equity of 14%. Because the two measures are identical in its case, the investor relations team uses the simpler return on equity label in its presentations to avoid confusing readers.
Example
An analyst comparing two utilities finds both report 12% return on equity, but one has a large preference share block. On a common equity basis the second company earns 12% and the first only 9%, which changes the recommendation.
Think of it
“Return on common equity shows what common shareholders earn-excluding preferred from the calculation.
Formula
Calculation
Return on Common Equity = (Net Income - Preference Dividends) / Average Common Equity
Take a mid-sized insurance broker. It reports net income of $6,000,000 and pays $600,000 of dividends on its preference shares. Common equity was $26,000,000 at the start of the year and $28,000,000 at the end.
Earnings available to ordinary shareholders = $6,000,000 - $600,000 = $5,400,000.
Average common equity = ($26,000,000 + $28,000,000) / 2 = $27,000,000.
Return on Common Equity = $5,400,000 / $27,000,000 = 0.20, or 20%.
Note that if you carelessly used the full $6,000,000 of profit, you would report $6,000,000 / $27,000,000 = 22.2%, overstating the return to ordinary owners by more than two percentage points.Case study
Seen in the real world.
This is an illustrative and fictional scenario. Kelsden Marine Services, an invented port handling company, raised $20,000,000 of preference shares carrying a 7% fixed dividend to survive a downturn. Trading recovered, and three years later the company reported net income of $4,200,000 and celebrated a return on total equity of just over 10%.
The ordinary shareholders were less impressed. The preference dividend absorbed $1,400,000 of that profit, leaving $2,800,000 for common holders against average common equity of $22,400,000, a return of 12.5%. That was better than the headline suggested in this instance, but the board realised the ratio would collapse if profit dipped, because the preference dividend had to be paid first regardless.
Management set aside cash each year with the aim of redeeming the preference shares. In this fictional example, buying them back removed the fixed prior claim and made the ordinary shareholders' return far less volatile, even though it left less cash for expansion in the short term.
Watch out
Common mistakes.
- Using total shareholders' equity as the denominator while also deducting preference dividends from the numerator. That mismatch understates the return; if preference dividends come out of profit, preference capital must come out of equity too.
- Forgetting cumulative preference dividends that were not paid in a loss year. Those arrears still rank ahead of ordinary shareholders and should be deducted when they accrue, not only when they are paid in cash.
- Reading a very high figure as proof of a superior business. Heavy borrowing shrinks the equity base and inflates the percentage without any improvement in underlying trading.
Questions
People also ask.
Is this different from return on equity?
Only when preference shares exist; without them the two measures are identical, which is why many companies use the terms interchangeably.
Should I use opening or average common equity?
Average is more accurate whenever shares have been issued or bought back during the year, since the profit was earned across the whole period.
Why do ordinary shareholders expect a higher return than lenders?
They are paid last and can lose everything if the company fails, so they demand compensation for taking the greatest risk.
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