By investing in a company, you become a partial owner. As an owner, you are entitled to a share of the company's profits. Before investing in a company that seems to generate a high income to its shareholders, make sure it has not issued shares of preferred stock. If it does, recalculate your expected earnings with the return on common equity calculation so you do not overestimate your total return.
A company's stock is divided between preferred shares and common stock. Common stock represents a pure ownership interest in the company. Common stock owners receive a share of the company's profits through dividends and have a voting right at the annual board of directors meeting. When a company makes payments, common stockholders get paid last, behind debt and preferred stock. As a result. common stock is a riskier investment than preferred stock. In exchange for the risk, common stock has a higher long-run growth rate than preferred stock.
Preferred stock is a hybrid between a stock and a debt instrument. These shares receive a fixed annual dividend that must be paid before any payments can be made to common stock. If the company goes bankrupt, preferred shareholders have a right to claim the company's remaining assets before the common shareholders. In exchange for this safety, preferred stock does not have the same growth potential as common stock. Preferred shareholders also do not get a vote at the shareholders meeting.
The total shareholder return calculation determines the annual profit for all shareholders in a company. To calculate total shareholder return, divide the company's annual net profit by its total number of shares outstanding. This calculates the profit earned for each shareholder in the company, both common and preferred. This is a useful formula if you are buying both common and preferred stock, or if the company has not issued preferred stock. This is not a good calculation for common stock holders because it does not take into account that the preferred dividend comes before any common stock dividends.
Return on Common Equity
The return on common equity calculation is more relevant for an investor researching common equity. To calculate the return on common equity, first subtract the preferred dividend from net profit and subtract the number of preferred shares from the total shares outstanding. Divide the adjusted profit by the adjusted number of shares to determine the remaining profit per share of common stock. Because preferred shares get paid in full first, this result may be significantly lower than the shareholder return if the company had low profits.