How can EPS increase while Return on Equity decreases?

Question

What would be the reasoning for this?

Answer 1

Return on equity is a measure of profitability. But getting better understanding of ROE requires you to look at its 3 primary components or ratios.

Net Margin: Net profit/ Sales

Asset Turnover: Revenue/ Assets

Equity Multiplier: Assets/ Shareholders Equity

A drop in any of these components will cause ROE to decrease.Let's consider how this may occur:

Net profit may drop as a percentage of sales. The proportionate profitability may fall, corporate income tax could rise and hence net after tax profits drop. Earnings may still grow under these circumstances, but ROE would fall.

If a business becomes more asset intensive...i.e. it requires more assets to generate sales, this would cause ROE to drop despite growing earnings.

Finally, if a company is paying down its debt, the equity multiplier will decline, since shareholders equity is equal to assets-long term debt. So a changing more conservative capital structure may result in a decline in ROE.

Hope this helps.