The Hustler's Digest StaffEarnings per share, or EPS, is a widely practiced metric used by many investors and analysts to estimate a company’s value per share. Read the full article to know what is EPS in stocks if you plan to invest.
EPS helps investors understand whether investing in a particular company is profitable. A consistent EPS growth may indicate its profitability, suggesting its ability to pay higher dividends over time. Investors have the question, “In what way is EPS useful to me as an investor?” and “what is EPS in stocks?”.
Earnings per share are significant to measure a company’s profitability. In fact, in fundamental analysis, EPS is the only metric that isolates net income to determine what the shareholders gain by investing in the company. Every company strives for a goal to rule in the market and make profits. EPS is an input in the P/E ratio that can help you compare the performance of promising companies and select the most suitable option.
Earnings per share can help you understand the company’s present financial standing and track its historical performance. For example, a company with a consistently rising EPS is often considered a safe investment option. Similarly, investors typically do not consider companies with declining or irregular EPS.
If you follow stocks and the market, one figure you will see a lot. Earnings per share tell you about a company’s profitability in a way that’s particularly useful to investors trying to judge whether to buy or sell individual stocks. To make a wise investment, you must have a thorough understanding of EPS in stocks. Proceed with this article to abreast yourself with the information we gathered.
What is earning per share?
Earnings per share or EPS is a standard metric used to carry out corporate value. It can be defined as the value of earnings per outstanding share of its common stock. Generally, a company represents EPS over different periods. Earnings per share contribute to each share; it arrives from the total income divided by the number of outstanding shares.
As an investor, you will primarily be interested in a stable source of income; the EPS ratio helps estimate the amount of room that a company has for increasing its existing dividend amount. However, in many cases, simply reviewing a company’s history of making changes to its dividend is a better indicator of the actual size of future dividends. In some cases, a company may have a high ratio but pays no dividend since it prefers to plow the cash back into the business to fund additional growth.
Why is EPS important to investors?
EPS is an important metric for an investor due to the following reasons.
A measure of profitability
Earnings per share are significant to measure a company’s profitability. In fact, in fundamental analysis, EPS is the only metric that isolates net income to determine the shareholders’ earnings by investing in the company. As laymen, we understand that a company is in the market to do business and make profits. Investors invest in companies to be a part of the company’s profitability.
A consistently growing EPS means that the investor is getting a share of the company’s growing profits consistently. Growing EPS also indicates that the company is creating value for its investors. In contrast, a consistently falling or negative EPS indicates financial trouble, low profitability or consistent losses, & eroding investor value. EPS answers two main questions for the investors. The first is “how much profit per outstanding share does a company make?” and the second is “how much profit is accrued to a shareholder?”
An indicator of payout dividend
Dividends are a portion of a company’s profits that the shareholders receive as a return on their investment. Investors like stable income associated with dividends. Investors also view dividends as a positive sign and indicator of strong growth in the future for the company. The company can only give dividends if it has excess earnings per share.
Although there is no direct relation between dividend payout and earnings per share, it is commonly seen that only those companies that have consistently stable or growing EPS pay dividends to their shareholders. Though dividends are very subjective and many things are considered before dividend payout, investors looking for dividend income should look at the company’s EPS before investing.
A determinant of the P/E ratio
Investors are more interested in the value that a particular stock or share brings to their portfolio than profitability. P/E ratio helps investors in valuing the shareholding. The critical determinant of the P/E ratio is EPS.
P/E ratio = Price per Equity Share/ Earnings per Share
Suppose company A has one equity share priced at USD 100, and its EPS for the year 2017 is USD 20. So its P/E ratio will be 100/20 = 5. This means at current profitability; it will take 5 years for the company to earn its market price per equity share. In other words, investors will have to keep their investment in the company for 5 years to recover their investment. Now let’s take company B; its market price per equity share is USD 1000 & its EPS is USD 100, so its P/E ratio will be 1000/100 = 10. This means the investors will have to stay invested for 10 years to recover their investment in the company.
Had we looked alone at the EPS, we would prefer company B as its EPS is $100, whereas the EPS of company A is $20. But looking at the P/E ratio, company A looks a much better choice at the much faster return on investment.
What is a good EPS?
What qualifies as a good EPS significantly depends upon the company itself and market expectations of how well that company will perform. As a general rule, the higher a company’s EPS, the more profitable it is likely to be, though a higher EPS is not a guarantee of future performance.
It is important to remember that how the company reports earnings and expenses can influence the quality and reliability of a company’s EPS ratio. If a company makes minimal adjustments to earnings or expenses with its accounting measures, then that could suggest the EPS ratio being reported is accurate. On the other hand, if a company reports large one-time expenditures or adjustments to earnings, that can skew the EPS ratio calculations. For example, if a company issues a stock buyback or acquires another company, adjustments to the numbers can temporarily increase or decrease the EPS ratio. Taking on large amounts of debt can also lead to manipulating the numbers.
How to evaluate EPS?
A better way to utilize EPS when evaluating companies is to compare ratios across similar companies within the same industry while also looking at historical trends. And it is essential to keep in mind that investor and market expectations can also affect profitability measures.
Making EPS comparisons across companies within the same industry or sector that are similar can give you a framework for determining what a good EPS is. For example, if you have two competing companies with similar business models, you can see their EPS ratios trends over time. If one company consistently outperforms the other when it comes to profitability, you could use its EPS as a benchmark for what is a good EPS.
Another way to evaluate how a company’s reported EPS changed over time is individual company trends. A company that shows a stable track record of reporting increasing EPS ratios quarter over quarter or year over year could signal that it is profitable and that its stock price is likely to continue increasing. When EPS ratios undergo sharp increases or decreases, on the other hand, that could suggest that a company’s profitability is less stable or sustainable.
Investors must always look at the broader picture when deciding a good EPS. When a market downturn or recession happens, it can have different consequences for individual market sectors. For instance, consumer staples might see a boost in a recession while consumer discretionary spending takes a dip. That can have a ripple effect on specific industries, such as travel, tourism, and hospitality, affecting EPS reporting.
Types of earnings per share
As an investor, you must know the types of earnings per share. Let’s present you with these types.
Reported EPS
Popularly known as the reported EPS, these earnings per share are based on the Generally Accepted Accounting Principles (GAAP). This is a required item on the financial statements submitted to the Securities and exchange commission’s financial statements. It is achieved using the Generally Accepted Accounting Principles and disclosed in the SEC filings. However, a company’s earnings can be distorted by GAAP.
If the income is generated through the one-time payment as operating income as per GAAP, it could trend the EPS upwards. If a business considers regular expenses unusual, it will artificially boost the earnings per share.
Pro Forma EPS
Pro forma” is a Latin phrase translated as “as a matter of form.” Whenever you encounter a pro forma EPS, it only means that the company has made assumptions about certain accounting items, especially about expenses, incomes, or acquisitions, to come up with pro forma earnings per share. Companies typically use this type of EPS to help improve their financial statements.
Retained EPS
Retained EPS means the company keeps the profit rather than distributing it to its shareholders as dividends. Several business owners use the retained earnings per share to pay off existing debts for primary purposes such as expansion or reserve them for future requirements.
You calculate retained EPS by adding the net earnings to the current retained earnings and subtracting the total dividend paid. The remainder is then divided by the total number of outstanding shares.
Retained EPS = (Net earnings + current retained earnings) – divided paid/total number of outstanding shares.
Cash EPS
Cash EPS helps to learn about a particular company’s financial standing. It signifies the exact amount of cash earned by the company. It is challenging to manipulate cash earnings per share. You can also determine a company’s liquidity by using this EPS, which factors in cash earned and changes in essential asset accounts, such as inventories and receivables. You can calculate EPS as:
Cash EPS = Operating Cash Flow/Diluted Shares Outstanding.
Book value EPS
Book Value EPS is used to calculate the average amount of company equity in each share. It can also be used to estimate the worth of a company’s stake if it has to be liquidated. It is a static representation of a company’s performance as it focuses on the balance sheet.
EPS formula
Earnings per share or basic earnings per share is calculated by subtracting preferred dividends from net income and dividing by the weighted average common shares outstanding. See the formula given below for a clear understanding.
Earnings Per Share = Net Income – Preferred Dividends / Weighted Average Shares Outstanding
You will notice that the preferred dividends are removed from net income in the earnings per share calculation. This is because EPS only measures the income available to common stockholders. Preferred dividends are set-aside for the preferred shareholders and cannot belong to the common shareholders.
Most of the time, earning per share is calculated for year-end financial statements. Since companies often issue new stock and buy back treasury stock throughout the year, the weighted average common shares are used. The weighted average common shares outstanding can be simplified by adding the beginning and ending outstanding shares and dividing them by two.
Earnings per share example
Weighted earnings per share is a more accurate calculation of EPS because it considers the dividends, also known as preferred stocks, that a company issues to its shareholders. A dividend is the amount of money a company pays out to its shareholders from its profit, usually every quarter. Here’s how to calculate it:
- Determine the company’s dividends on preferred stocks.
- Subtract the company’s dividends from its annual net income.
- Divide the difference by the average amount of outstanding shares.
Here is an example calculation for weighted EPS:
A company’s net income from 2019 is 15 billion dollars, they pay a 2 billion dividend to shareholders for the year, and they have 4 billion shares outstanding.
Weighted earnings per share = (15 billion – 2 billion) / 4 billion
Weighted EPS = 13 billion / 4 billion
Weighted EPS = 3.25
EPS carries significance in terms of a company’s profitability, performance, and value, which is important information for you as an investor. Here’s how to interpret EPS results:
- A higher EPS means a higher payout.
- Use EPS to compare companies.
- Use EPS growth trends to forecast future profitability.
- Use EPS to determine stock value.
Negative EPS
The earnings-per-share is a function of a company’s net income and the number of its outstanding shares. Since a business can not possibly consist of negative shares, negative earnings are the only reason for a negative EPS. Negative earnings reflect the company’s loss in the given period, meaning that the business could not generate revenue or income beyond its total operational costs.
What does a negative EPS mean?
A negative earnings-per-share reflects a company’s unprofitability which should not be a positive sign for most investors. Companies with poor financial health, temporary distress, or bad operational efficiency will usually report negative earnings due to such problems. However, before jumping to the quick conclusion that the business you’re analyzing is terrible due to its negative earnings, it would be worth looking for what exactly has led the business to be unprofitable in the first place.
Some companies can report a negative EPS on a given period due to a substantial one-time expense which distorts the earnings number for the specific time frame.
Many unprofitable businesses are usually still early in their business life cycle, where negative earnings are the rule rather than the exception. It takes time to establish and grow a working business model until profits can finally be generated. Either way, it would make sense to assess the individual circumstances of any given company first before labeling it as a bad investment.
In the following, we will go through some approaches that you can take to assess different companies reporting negative earnings-per-share.
Assessing the history of the company’s EPS
It will not be fair to evaluate one single EPS figure to give insights into a company’s performance. If the company’s current earnings-per-share is negative, you could look at past EPS measures to better context the firm’s performance
For example, a business that has constantly been generating positive earnings in the past periods, but suddenly reports negative earnings due to some temporary incident or event, is likely to recover and become profitable again. Another firm that was consistently unprofitable for years due to a poor business will be in a completely different situation even if both currently report negative earnings.
Using other metrics instead of EPS
Earnings-per-share is only one of the many metrics that investors can use to analyze a company’s financial performance. Several other measures may be used to assess a firm’s financial performance even if it isn’t profitable:
- Operating income is also a profitability measure and represents the earnings that a business has generated from its operations. Suppose the net income of a company is negative. Operating income could be positive since non-operational costs such as interest expenses and taxes payments are not subtracted yet.
- EBITDA is an acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization. Compared to operating income, it even strips out non-cash charges like depreciation and amortization to account for a firm’s operational performance in a supposedly more accurate way.
- Gross & Operating Margins. An excellent way to assess a company’s efficiency is using profitability ratios like the gross and operating margin, which gauge the percentage of generated income in two different stages within an income statement. The gross margin represents the amount of retained revenue after incurring associated costs, while the operating margin measures the active income as a percentage of revenue.
Analyzing the firm’s cash flows
Many investors and companies often overlook the importance of cash flows while focusing too much on the earnings-per-share metric and whether it has beaten expectations. The company’s shareholders should care about the cash flows that the business generated, which can then be returned in the form of dividends or share buybacks. In practice, cash flows are rarely the same as earnings because accountants record the income and expenses within a business to consistently provide and standardize financial information across all companies.
Using EPS to choose stocks
When comparing different stocks, it is helpful to use the EPS ratio as a guide. If a company is posting year-over-year continued EPS growth, that could be a sign that it can sustain profits over time. Conversely, if a company has a downward trending EPS or is reporting a negative EPS, that could indicate that it’s stuck in a pattern of losing money.
Aside from EPS, however, remember to consider other measures of financial health. The price to earnings ratio, for example, measures a company’s price relative to its EPS. The higher a company’s P/E ratio, suggests that higher the earnings are expected. But again, this isn’t a guarantee that a company’s performance will meet or exceed expectations. And a higher price-to-earnings ratio could also suggest that a company is overvalued.
The more metrics you use to compare stocks, the more accurate a picture of its health you may be able to create. Looking closely at EPS, price to earnings, and other measures can also help you spot and avoid value traps if you follow a value investing strategy.
Conclusion
Earnings per share is an important indicator to check the value of your stocks. It is also an important component used for calculating the price to earnings (P/E) valuation ratio. In the P/E ratio, the E stands for EPS. By dividing a company’s stock price by its EPS, you can calculate the share value of how much the market can afford to pay for each earned dollar. It is essential to determine EPS for its stock price, P/E ratio, or earning’s yield. Compared to the last quarter, a low EPS number might still lead to a surge in share price if analysts were expecting a worse figure.
