Earnings per share is a crucial investment metric to pay attention to when investing in the stock market, as it paints a clear picture of where a company stands in terms of growth and profitability. Investors, analysts, and even CEOs pay close attention to this number, given its potential impact on stock prices.
What are Earnings per Share?
Simply put, earnings per share (EPS) is a metric that indicates how much was earned by the portion of a company represented by one share of stock, during a given time. Since companies vary widely in size and earnings, and since they all issue a different number of shares, knowing the ratio of earnings to share helps put a company’s earnings in perspective.
Earnings per share metrics are arrived at by dividing the company's net income by the total number of outstanding shares. The higher the number, the more potentially valuable each share of stock. When a company reports a net loss, its earnings per share will also be a negative number.
This measure is of great importance to income-focused investors looking for a steady source of income. The metric also provides insights on whether there is room for a company to increase its current dividend. However, the metric should never be analyzed in isolation when making critical investment decisions. Instead, it should be compared with the industry average to get a clear idea of how the company is performing relative to other companies, subjected to the same macroeconomic conditions.
How to Calculate Earnings Per share
Earnings per share is calculated by dividing net income (amount of money left after deduction of appropriate expenses and taxes from revenues) by the total number of shares issued.
A company’s balance sheet and income statement are needed for the calculation of earnings per share. They provide information about the total number of shares outstanding and the net income generated over a given period. EPS is usually calculated for periods of three months or 12 months.
These financial documents also provide information on expenses that must be taken into account before calculating EPS, such as dividends on preferred stock. EPS can be calculated by subtracting a company's preferred dividend from its net income and dividing by the number of outstanding shares.
A company with a net income of $100 million, $20 million in preferred dividends and forty million in outstanding shares will have an EPS of:
(100,000,000 - 20,000,000) / 40,000,000 = $2 per share
For accuracy, the weighted average number of shares outstanding over the reporting term is usually used for EPS calculation, given that the number of shares outstanding can change over time.
Earnings per share are calculated in two ways
1) Dividing net income after tax by the total number of outstanding shares: (Net income/ Outstanding Shares)
2) Weighted earnings per share: (Net Income after Tax - Total Dividends)/ Total Number of Outstanding Shares.
A critical aspect of EPS that is usually bypassed has to do with the amount of capital used to generate net income. Two companies might have the same EPS even though they used a different amount of capital. Efficient companies tend to use a limited amount of resources, in terms of capital, to generate a substantial amount of income.
Investors also need to be wary of earnings manipulation that at times come into play as companies try to strengthen their sentiments in the market. Because earnings data and earnings forecasts can be affected by a company’s choice of accounting practices, it is important not to rely on one financial measure when trying to evaluate a company's long-term prospects.
Types of Earnings per Share
There are three types of EPS, based on what data is used to calculate them.
Trailing EPS - Based on Previous Years Numbers
A trailing EPS has the benefit of using actual numbers, especially on outstanding shares as it uses previous quarters’ earnings for calculations. Price to earnings, another crucial financial metric, uses trailing EPS in its calculation because it provides an explicit representation of what happened and what is likely to happen.
Even though it is a more accurate form of EPS, investors tend to look at the current and forward EPS figures to gauge the actual status of a company when it comes to performance.
Current EPS- Based on Current Years Numbers
Current EPS is an up-to-date earnings per share ratio that paints a clear picture of how a company has performed in the current fiscal year. The measure includes data for the four quarters of the current fiscal year. It relies on data for quarters that have already elapsed as well as projections for quarters yet to come.
Forward EPS- Based on Projections
Forward earnings per share is based on projections for a given period in future. Both the company and analysts usually look at forward EPS as they try to predict how a company is likely to perform.
Investors pay close attention to this metric as it gives an idea of how the stock is likely to perform in future and how the stock’s price might change.
What does EPS Indicate?
EPS is an important measure for valuing a company, as it breaks down earnings on a per share basis. As the number of a company’s outstanding shares change, so does the metric. It is for this reason that companies try to reduce the number of shares in the market by limiting issuance and carrying out buybacks as a way of ensuring steady or rising EPS.
Earnings per share tend to have a considerable impact on stock prices in the market. Companies with higher EPS tend to command strong stock prices in the market because each share of the company is seen as more valuable. High EPS is an indicator of productivity and revenue generation with low operations costs. Rising EPS can also show that the company is growing. Weak EPS, on the other hand, is synonymous with weak stock prices.
A higher EPS also indicates that a company could be profitable enough to be in a position to pay out some money to shareholders. Such earnings may come out in the form of a dividend, or a company may decide to carry out a buyback in a bid to return value to shareholders.
To get an idea of how a company has been performing over a given period, it is essential to watch for trends in its EPS. In this case, a company with a steady EPS growth would act as a reliable long-term investment.
Earnings per share are also used to calculate Price to Earnings (P/E) ratio, another critical financial metric for analyzing a company.
How to use Earnings Per Share for Stock Selection
Earnings per share is an important metric worth considering before investing in any stock. However, looking at the metric outright, without looking at other metrics or comparing it with that of other companies, will not be useful.
Let’s say we have two companies, Company X and Company Y, both of which have gross revenues of $500 million. In this case, one may be swayed to think that the two companies are equal when it comes to performance. However, that might not be the case.
After looking at revenues, it is essential to pay close watch to net income as well. Let’s say Company X brought in $100 million in net earnings in the quarter, upon deduction of taxes and expenditure, while company Y brought in only $50 million. It might appear that Company X has the upper hand over company Y at this juncture, which could be true in some sense.
However, calculation of earnings per share puts the share value of these two companies in a different light.
Let’s say Company X had 50 million shares of outstanding shares while company Y had 10 million shares of outstanding shares.
Calculating earnings per share:
Company X EPS= (100,000,000/50 million shares) = $2 per share
Company Y EPS = (50,000,000/10 million shares) = $5 per share
From the computation above, it is clear that each stock of Company Y would be more valuable to shareholders, at $5 earnings per share, despite generating half of Company X net income.
Earnings per share is thus a more important stock selection tool than net profit, as it highlights a company’s performance relative to the number of shares issued. Net profit might increase nicely, but if outstanding shares are also rising, then earnings per share might be flat or edge lower.
What is a good EPS?
Earnings per share manipulation is one of the oldest professions. That said it is essential for investors to be cautious while evaluating a company in terms of earnings per share. A high-quality EPS acts as an accurate representation of what a company actually earned. A low-quality EPS, on the other hand, does not portray a company's actual earnings. By digging deeper into a company’s income statements and balance sheet, investors can get a better idea of the company’s true cash flow.
Healthy earnings per share in the stock market comes down to expectations. Analysts and corporate executives identify a range, in which a company’s profits or earnings are expected to range in a given quarter. In this case, a good EPS is one that lies within the range or exceeds the range.
Earnings per share are also evaluated in comparison with figures reported in the previous year or quarter. Healthy earnings per share ratio, in this case, is one that beats the previous year or quarter EPS. A consistently rising EPS is always a positive sign, as it underlines robust growth. A drop in EPS compared to the previous year is never a good sign.
A corporation’s earnings are also considered good when it outperforms those of similar companies in the same sector. Comparison, in this case, is essential as companies in the same sector will always experience the same macroeconomic factors in a given period.
What is the difference between EPS and P/E Ratio?
Just like earnings per share, price to earnings ratio (also known as an earnings multiple) is a widely used investment ratio. For an investor to get the best deal when it comes to stock investment, the two metrics should be taken into consideration prior to considering a buy position.
Price/Earnings ratio (P/E) is commonly used to measure a company’s stock price in relation to earnings per share. The ratio is arrived at by dividing stock price by earnings per share and is particularly useful for valuation purposes.
Unlike earnings per share, which measures a company’s profitability relative to shares issued, the price to earnings ratio underscores the market’s opinion of the earnings capacity. The ratio also tries to highlight future business prospects. Companies that enjoy high investor confidence tend to command a high P/E ratio.
P/E indicates the amount of money investors are willing to pay for every dollar of earnings. The ratio offers insight into a stock's growth potential because investors are willing to pay more for each dollar of earnings only if they believe that EPS will increase in the future.
If a stock has an annual EPS of $2 and a stock price of $40 a share, then the P/E ratio will be:
P/E = $40 / $2 = 20
A high P/E ratio indicates that investors expect a company to report higher earnings in the future. However, a higher P/E could also indicate that a stock is overvalued and it is not a good time to buy.
A low P/E indicates that a stock is undervalued providing investors an opportunity to buy a stock on the low. On the other hand, companies with high current earnings but dim prospects tend to also command low P/E ratios.
Before making any investment decision, one should always pay close attention to the prospects of a company and not so much on its present performance. It is for this reason that companies with low current earnings but bright prospects usually command high P/E.
Bottom Line
Earnings per share make the most sense when looking at both historical figures and future estimates. That way, one would be able to gauge whether the company’s profitability is increasing or decreasing. In addition, it should be compared with that of other companies in the sector to get an understanding of whether a company is underperforming or outperforming the overall market. Earnings per share can then be used to put the stock’s current price in perspective in order to make buying and selling decisions.
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