The rate earned on stockholders' equity, also known as the return on stockholders' equity or just return on equity, expresses a relationship between a company's net income and its stockholders' equity. The ratio indicates management's effectiveness in generating a return on the shareholders' invested capital. Stockholders' equity is part of a company's balance sheet, while net income is part of the income statement.
Stockholders' equity is equal to assets minus liabilities. For example, if assets are $10 million and liabilities are $4 million, then stockholders' equity is $10 million minus $4 million, or $6 million.
Stockholders' equity consists of contributed capital, which is what the owners or shareholders have invested, and retained earnings, which are the accumulated profits after paying dividends. Contributed capital includes the par value of the company's common and preferred stock and the paid-in capital, which is the difference between the issuance price and the par value. For example, if the company issues 1 million common shares of $1 par value stock at $5 each, the par value is equal to $1 multiplied by 1 million, or $1 million, and the paid-in capital is equal to ($5 minus $1) multiplied by 1 million, or $4 million, for a total contributed capital of $1 million plus $4 million, or $5 million. If the retained earnings balance is $2 million, the stockholders' equity is $5 million plus $2 million, or $7 million.
Gross profit is equal to sales minus costs of goods sold. Operating profit is equal to gross profit minus operating expenses, such as general and administrative expense, selling expenses and office expenses. Net income is equal to operating profit minus non-operating expenses, such as interest and taxes.
The rate earned on stockholders' equity is equal to a company's net income divided by its stockholders' equity, expressed as a percentage. For example, if the net income is $1 million and stockholders' equity is $10 million, the rate earned on stockholders' equity is equal to 100 multiplied by ($1 million divided by $10 million), or 10 percent. A variation of this formula is the return on common equity, which is equal to the (net income minus preferred stock dividends) divided by the (stockholders' equity minus the par value of preferred stock), expressed as a percentage. Continuing with the example, if the preferred dividend payments are $200,000 and the par value of preferred stock is $1 million, then the return on common equity is equal to ($1 million minus $200,000) divided by ($10 million minus $1 million) multiplied by 100, or ($800,000 divided by $9 million) multiplied by 100, or 8.89 percent.
The rate earned on stockholders' equity calculation has certain limitations. Financial ratios generally are more meaningful when compared against historical trends and among companies in the same industry sector, rather than as standalone numbers. This is also true for the rate earned ratio, because it varies across companies and industry sectors. Management actions might lead to a higher ratio, even if the company does not generate additional profits. For example, a stock buyback decreases stockholders' equity and increases the rate earned on the stockholders' equity, even though the company may not have generated additional profits.