One important step in evaluating stocks for investment is to understand the level of profitability of the company represented by the stock. Both return on equity and earnings per share are measures of profitability. Each of these profitability measures tells you something a little different concerning how well the company's executives are managing the business.
Earnings of a Company
The earnings of a company may also be referred to as the net income. Earnings start with the total sales or revenue for a year. Then, all of the expenses incurred to make those sales are subtracted, including items like cost of goods sold, wages, interest expenses and taxes. The result is the net income or earnings for the year. The earnings, which show up on the company's income statement, are often referred to as the "bottom line," since the net earnings are the last, or near the last, item listed on the income statement.
Return on Equity
Return on equity is the net earnings divided by the company's equity. Equity equals the assets of the company minus the liabilities; the equity amount shows up on the company's balance sheet. Return on equity can be viewed as the return on the investments the company has made. As a simplified example, let's say your company assets consist of one machine for which you paid $10,000. Your income, after expenses from the output of that machine, was $1,000 for the year. That means your company had a return on equity of 10 percent.
Earnings Per Share
Earnings per share is the net income or earnings divided by the number of shares outstanding. This calculation puts a value on the stock share price in relation to profitability of the company. If the stock of one company has a share price of $100, and the share value of another is $20, the two stocks have a similar valuation if the earnings per share is the same. Therefore, earnings per share can be used as a means of quickly comparing the relative value of two different stocks. A higher earnings per share means a stock has a higher valuation than a stock with a lower earnings per share.
The return on equity is used to determine the profitability of a company. A company with a 20-percent return on equity is generating more profits from its assets than a company with a 10-percent return on equity. Investors also want to make sure the return on equity of stocks owned stays level or increases over time. The earnings per share measurement relates to the earnings growth of a company. In general terms, a stock is fairly valued if the earnings per share is similar to the annual growth rate of a company. A stock with an earnings per share of 20 should be growing faster than a company with an earnings per share of 10.
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- As an Investor, Do You Want a Stock to Have a High or Low P/E Ratio?
- How to Calculate an Equity Multiple
- The Concept of Valuation
- How to Calculate External Equity
- How to Compare Dividend Yields
- What Are the Benefits of Return on Equity?
- How do I Evaluate the Performance of Stock Market Investments?