When looking at a company's financial profile, you should come prepared with a good understanding of what the numbers mean. Two important metrics are return on equity (ROE) and earnings per share (EPS). Both numbers give a good indicator of the company's success or failure and are an important basis for the performance of the company's publicly traded shares.
Earnings Per Share
Add up a company's gross revenues, subtract all expenses and costs, and you have net earnings. When you divide the earnings by the number of public shares, you arrive at earnings per share. The EPS number is the most basic measure of a company's success, and it is calculated every quarter. When EPS is rising, shares join the upward climb. When it is falling, then shares tend to tumble. Market analysts closely follow the EPS trend and issue estimates before the company releases the number; beating or failing to meet the estimates has a major impact on share price.
EPS and P/E
Most stocks trade at a multiple of EPS, and this is where the price/earnings or PE ratio comes in. If a company makes $1 a share, and is priced at $10, then its P/E ratio stands at 10. A higher P/E ratio means the company is drawing more buying interest than the average; its shares are generally a riskier bet. Low P/E means either the company is quite stable and predictable, and thus a low-risk investment, or its earnings have suffered. Some industries, such as biotech or electronics, tend to have higher P/Es than others, such as utilities or banks.
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Return on Equity
Return on equity is somewhat comparable to earnings per share, with the net earnings divided by shareholders' equity rather than the number of shares outstanding. The calculation uses only annual results, however, with the total earnings for the year divided by the average shareholders' equity. Shareholders' equity equals the total assets minus the total liabilities, as calculated on a company’s balance sheet. A company with $11 million in assets and $1 million in liabilities has $10 million in shareholders' equity. If the company has earned $1 million in a year, its return on equity for that year is $1 divided by $10, or 10 percent.
ROE vs. EPS
The ROE is a better gauge than simple EPS of how a company is deploying its capital to build a profitable business. The higher the ROE, the more wealth the company is creating for its shareholders, and the better return they can expect from their investment. A company’s ROE should be compared to that of its competitors and other companies in the same sector, whereas EPS and P/E ratios are better used as a gauge of whether the shares themselves are over or undervalued.