This ratio comprises two elements: the amount of profit made
and the number of shares in issue. When a company sets a profit target
for the year this will directly affect the way the business is managed.
If it is an aggressive target, management will be under pressure to generate
lots of sales and keep a firm grip on costs. If it is an easy target
managers can be more relaxed because, even if sales fall slightly or
costs start to increase, the profit target will still be achieved.
Now let’s turn our attention to the other determinant of earnings
per share: the number of shares in issue. What effect does this have on
how a company is run? The answer is simple – it doesn’t! Most managers
probably haven’t got a clue how many shares are in issue in their
company; nor do they care. Earnings per share is an investors’ measure:
shareholders want to know how much profit is being earned on
each share they hold. This is of no relevance to managers (unless, of
course, they are also shareholders).
From a managerial viewpoint, what is relevant is the funds
received in exchange for the shares. When shareholders invest $5 million
in a company, for example, its managers must decide what they
are going to do with that $5 million. This does affect how the business
is managed. It follows that managers find it far more useful to look at
profit in relation to shareholders’ funds invested, rather than in relation
to the number of shares in issue. This has led to the development
of a measure known as ‘return on equity’ (often abbreviated to ROE),
which looks at profit as a percentage of shareholders’ funds:
Profit
Return on equity = x 100%
Shareholders’ funds
A SMALL MATHEMATICAL POINT
Whenever a calculation ends with the expression ‘x 100%’, this means
that the result should be multiplied by 100. In other words, it should be
expressed as a percentage (literally ‘per one hundred’).
‘Return’ is just another word for profit, while ‘equity’ is an alternative
term for the owners’ money invested in the business
and the number of shares in issue. When a company sets a profit target
for the year this will directly affect the way the business is managed.
If it is an aggressive target, management will be under pressure to generate
lots of sales and keep a firm grip on costs. If it is an easy target
managers can be more relaxed because, even if sales fall slightly or
costs start to increase, the profit target will still be achieved.
Now let’s turn our attention to the other determinant of earnings
per share: the number of shares in issue. What effect does this have on
how a company is run? The answer is simple – it doesn’t! Most managers
probably haven’t got a clue how many shares are in issue in their
company; nor do they care. Earnings per share is an investors’ measure:
shareholders want to know how much profit is being earned on
each share they hold. This is of no relevance to managers (unless, of
course, they are also shareholders).
From a managerial viewpoint, what is relevant is the funds
received in exchange for the shares. When shareholders invest $5 million
in a company, for example, its managers must decide what they
are going to do with that $5 million. This does affect how the business
is managed. It follows that managers find it far more useful to look at
profit in relation to shareholders’ funds invested, rather than in relation
to the number of shares in issue. This has led to the development
of a measure known as ‘return on equity’ (often abbreviated to ROE),
which looks at profit as a percentage of shareholders’ funds:
Profit
Return on equity = x 100%
Shareholders’ funds
A SMALL MATHEMATICAL POINT
Whenever a calculation ends with the expression ‘x 100%’, this means
that the result should be multiplied by 100. In other words, it should be
expressed as a percentage (literally ‘per one hundred’).
‘Return’ is just another word for profit, while ‘equity’ is an alternative
term for the owners’ money invested in the business
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