Return on equity and earnings per share are profitability ratios. ROE measures the return shareholders are getting on their investments. EPS measures the net earnings attributable to each share of common stock. Companies usually provide EPS and other ratios in their quarterly and annual reports. You can also derive these ratios from the financial statements in these reports.
Earnings Per Share
EPS is the net income divided by the weighted average number of common shares issued and outstanding expressed in dollars per share. Net income is equal to sales minus the sum of cost of goods sold and operating and non-operating expenses. Operating expenses include administration and marketing, while non-operating expenses include interest and taxes. Subtract any preferred dividend payments from the net income for calculating the EPS. The weighted average share count factors in the time each share has been outstanding. For example, if 3 million and 6 million common shares were outstanding for four and eight months, respectively, the weighted average share count for the year is 3 million multiplied by (four divided by 12) plus 6 million multiplied by (eight divided by 12), or 5 million. If the net income after paying preferred dividends is $1 million, the EPS is $1 million divided by 5 million shares, or 20 cents per share.
Return on Equity
ROE is net income divided by average shareholders' equity expressed as a percentage. The average shareholders' equity is equal to the average of the beginning and ending amounts over a measurement period. For example, if the starting and ending shareholders' equity amounts are $5 million and $15 million, the average is $10 million. If the net income is $1 million, the ROE is equal to $1 million divided by $10 million, or 10 percent. Preferred shares and dividends are not part of the calculations.
ROE indicates management's ability to generate a return for each dollar of common equity investment. EPS measures the return on a per-share basis. A high ROE usually means market dominance and pricing power, while a low ROE normally means that a combination of competitive forces and poor execution is squeezing the bottom line. The price-to-earnings ratio is the ratio of the current stock price and the trailing 12-month EPS. Companies with steadily growing EPS ratios usually enjoy high PE multiples relative to the industry or market average. However, declining or negative EPS ratios usually mean deteriorating fundamentals.
You should look deeper behind the ROE and EPS numbers because investing and financing activities can affect the data. For example, if a company issues shares to raise capital, the ROE and EPS ratios could fall in the short term. If a company issues bonds to buy back its common shares, both ROE and EPS numbers would increase because of lower average shareholders' equity and share count, respectively. You should note that in either case the net income or earnings power might not be affected at all.
Based in Ottawa, Canada, Chirantan Basu has been writing since 1995. His work has appeared in various publications and he has performed financial editing at a Wall Street firm. Basu holds a Bachelor of Engineering from Memorial University of Newfoundland, a Master of Business Administration from the University of Ottawa and holds the Canadian Investment Manager designation from the Canadian Securities Institute.