Return on Equity

1. Compute and explain return on equity.

2. Discuss the reasons that earnings per share (EPS) figures are so closely watched by investors.

3. Calculate basic EPS with or without the existence of preferred stock.

4. Explain the relevance of the P/E ratio.

5. Identify the informational benefit provided by diluted EPS.

Question: Throughout this textbook, various vital signs have been presented. They include ratios, numbers,

percentages, and the like that are commonly studied by investors as an indication of current financial health and

future prosperity. One common measure is return on equity (ROE). How does an interested party calculate the

return on equity reported by a business?

Answer: Return on equity reflects the profitability of a company based on the size of the owners’ claim to net

assets as shown primarily through contributed capital and retained earnings. It is simply the reported net income

divided by average shareholders’ equity for the period.

return on equity = net income/average shareholders’ equity

For example, PPG Industries began 2008 with total shareholders’ equity of $4,151 million and ended that year

with a balance of $3,333 million. For the year ended December 31, 2008, PPG reported net income of $538

million for a return on equity of 14.4 percent.