A corporation’s board, management and investors are keenly interested in the amount of profit created each quarter. Stock prices and executive careers often hang in the balance. Earnings per share (EPS) and return on equity (ROE) are critical metrics describing a corporation’s profitability and how efficiently it generates its profits.
There are several ways to calculate EPS, one of which uses ROE. You can also use an online earnings per share calculator or find a corporation’s ROE and EPS directly on finance news sites for public companies.
What Is Return on Equity?
A firm’s ROE equals net after-tax earnings divided by stockholders’ equity.
[Equation 1]: ROE = Net income/stockholders' equity
Stockholders’ equity is the sum of paid-in capital – the funds raised from the sale of stock and warrants – and retained earnings, which is the amount of accumulated profit.
ROE measures how efficiently a corporation generates income per dollar of invested equity (i.e. its capital, or assets, minus liabilities). A high ROE means that a company is efficiently converting its capital into profits and therefore experiencing a solid growth rate. ROEs are most meaningful when they compare different firms within the same industry.
What Are Earnings Per Share?
Earnings, aka a company’s net income or net profit, is a precise accounting term describing the company’s profit realized after deducting all expenses and taxes from revenue, according to Investor.gov. It is the company’s bottom-line profit or loss before it pays dividends.
Net income is reported quarterly and annually on a corporation’s income statement. This amount increases the firm’s retained earnings, or accumulated profits, as reported in the stockholders’ equity portion of the balance sheet.
Using the earnings per share formula involves dividing the net income by the number of common stock shares. You can use the average number of outstanding common shares for the period or the number at period close.
[Equation 2]: EPS = Net income/common stock shares
In some versions of the EPS formula, preferred dividends (i.e. dividends from preferred stock) and extraordinary items are subtracted from net income to identify the income from continuing operations.
Equation 2 refers to the basic earnings EPS value. Diluted EPS accounts for an additional number of shares created through stock options, stock splits, stock dividends, warrants, convertible bonds and restricted stock units.
EPS Calculation Using ROE
You can look up a company’s ROE on a financial news site or calculate it using Equation 1 from information on the corporation’s balance sheet and income statement.
For example, suppose a company has $700 million in stockholders’ equity, $100 million in earnings, 500 million outstanding shares of common stock and no preferred shares. From Equation 1, its ROE is $100M/$700M, or 14.2857 percent. You must analyze this number compared to the ROEs of competing companies within the industry.
You can calculate EPS by first rearranging Equations 1 and 2 to solve for net income:
[Equation 1A]: Net income = ROE x stockholder’s equity
[Equation 2A]: Net income = EPS x common stock shares
Simultaneously solving the two equations gives us the following:
[Equation 3]: ROE x stockholder’s equity = EPS x common stock shares
Now, rearrange the equation to solve for EPS.
[Equation 3A]: EPS = (ROE x stockholder’s equity)/common stock shares
Substitute to find EPS:
EPS = (14.2857 percent x $700M)/500M shares = $0.20 per share.
Analyzing the Calculated EPS to Make Investment Decisions
EPS is meaningful in two principal ways:
- To measure how well a corporation is earning profits relative to its competitors
- To review how a corporation’s earnings have evolved over a period of time
Investors can gauge a corporation’s profits relative to similar companies by evaluating EPS industry-wide. All things being equal (which they seldom are), investors should prefer a company with a higher EPS to that with a lower one, as it may indicate the former is more efficient at converting assets to income.
EPS also shows the company’s earnings trends over time to see whether the corporation’s earnings are growing, stable or declining.
The EPS ratio is most useful for calculating a stock’s price-to-earnings (P/E) ratio, which according to Investor.gov is:
[Equation 4]: P/E = Share price/EPS
Investors use the P/E ratio to measure how much the stock market will pay for each dollar of a corporation’s earnings. The higher the P/E, the more expensive each share of common stock and the higher the anticipated growth rate. Growth investors may favor high P/E stocks, whereas value investors seek bargain stocks with low P/Es. Earnings disappointments (i.e. a lower-than-expected EPS) can harm a stock’s price and drag down its valuation.
- Compare a company's EPS over different years to track its changes. A consistently rising EPS suggests the company is growing its profits, which could lead to a higher stock price.
- Compare the EPS between companies in an industry. The company with a higher EPS generates profits more efficiently for stockholders.
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.