Chartered Financial Analyst (CFA) Level 1 Practice Exam

What is the formula for Return on Common Equity?

1. (Net Income - Preferred Dividends) / Average Common Equity

2. (Net Income + Preferred Dividends) / Average Common Equity

3. Net Income / Total Common Equity

4. (Net Income - Preferred Dividends) / Total Assets

The correct answer is: (Net Income - Preferred Dividends) / Average Common Equity

Return on Common Equity (ROE) measures the efficiency of a company in generating profits from the equity invested by common shareholders. The fundamental purpose of this metric is to reflect how well a company utilizes the shareholders’ equity to create earnings. The correct formula for ROE is derived by taking the net income available to common shareholders, which is net income minus any preferred dividends, and dividing it by the average common equity over the same period. This approach ensures that the return is accurately measured based only on the equity invested by common shareholders since preferred shareholders have different rights and claims on income. Using average common equity rather than total common equity helps to smooth out any fluctuations over the period, giving a more accurate view of shareholder returns. This is particularly useful in cases where equity can vary significantly during a reporting period due to new issuances or buybacks. Thus, the choice that specifies net income subtracting preferred dividends over average common equity correctly encapsulates how ROE is determined and is the reason it is the appropriate answer.