Knowing a stock’s earnings per share can be a valuable portfolio benchmarking tool. Think of EPS as GPS for where a public company is on the value map, based on how profitable it has been.
What is earnings per share? It’s a ratio arrived at by taking a company’s quarterly or annual net income and dividing it by the number of its outstanding shares of stock.
Knowing an investment’s EPS gives investors—and portfolio managers—a good indicator of a stock’s performance over a specific period of time and its potential share price performance in the near future.
What is Earnings Per Share?
The starting point for any conversation about the EPS ratio is the earnings report companies issue to regulators, shareholders, and potential investors.
Publicly traded companies must, by law, report their earnings quarterly and annually. Earnings represent the net income a company generates (after taxes and after expenses are deducted), along with an estimate of what profits or losses can be expected going forward.
Typically, investment analysts, money managers and investors look at earnings as a major component of a company’s profit potential, with earnings per share a particularly useful measurement tool when gauging a company’s financial prospects.
While a company’s earnings call represents a publicly traded company’s revenues, minus operating expenses, earnings per share is different.
EPS indicates a firm’s earnings for investors, divided by the company’s number of remaining shares. Earnings per share is perhaps most optimal when comparing EPS rates of publicly traded firms operating in the same industry.
evaluate a company’s stock price going forward.
Even a moderate increase in EPS may indicate that a company’s profit potential is on the upside, and investors may take that as a sign to buy the company’s stock.
Conversely, a small decrease in a company’s EPS from quarter to quarter may trigger a red flag among investors, who could view a downward EPS trend as a larger profit issue and shy away from buying the company’s stock.
Basically, the higher the EPS, the more attractive that company’s stock is to investors. But the higher a stock’s EPS, the more expensive it’s likely to be.
Once investors have an accurate EPS figure, they can decide if a stock is priced fairly and make an appropriate investment decision.
Earnings Per Share Ratio Considerations
Investors should prepare to dig deeper and examine what factors influence EPS figures. These factors are at the top of that list:
• EPS numbers can rise or fall significantly based on earnings’ rise or fall, or as the number of company shares rises or falls.
• A company’s earnings may rise because sales are surging faster than expenses, or if company managers succeed in curbing operations costs. Additionally, investors may get a “false read” on EPS if too many company expenses are shed from the EPS calculation.
• A company’s number of outstanding shares may fall if a company engages in significant stock share buybacks. Correspondingly, shares outstanding may jump when a firm issues new stock shares.
• A company’s profit margins are also a big influencer on EPS. A company that is losing money usually has a negative EPS number. (Then again, that may send a wrong signal to investors. The company could be on the path to profits, and that trend may not show up in an EPS calculation.)
• A price to earnings ratio is another highly useful metric to evaluate a stock’s share growth potential. Investors can find a P/E ratio through a proper calculation of EPS (“P” is the price per share; “E” refers to EPS), though it’s easy to look up a P/E ratio on any site that aggregates stock information.
EPS can be reported for each quarter or fiscal year, or it can be projected into the future with a forward EPS.
How to Calculate Earnings Per Share
The most common way to accurately gauge an EPS figure is through an end-of-period calculation. Here’s a snapshot of how it works.
With Preferred Dividends
Investors can calculate EPS by subtracting a stock’s total preferred dividends from the company’s net income. Then divide that number by the end-of-period stock shares that are outstanding.
Basic EPS = (net income – preferred dividends) / weighted average number of common shares outstanding
For example, ABC Co. generates a net income of $2 million in a quarter. Simultaneously, the company rolls out $275,000 in preferred dividends and has 12 million outstanding shares of stock. In that calculation, knowing that shares of common stock are equal in value, the company’s earnings per share is $0.14.
(2,000,000 – 275,000) ÷ 12,000,000＝ 0.14
Without Preferred Dividends
For smaller publicly traded companies with no preferred dividends, the EPS calculation is more straightforward.
Basic EPS = net income / weighted average number of common shares outstanding
Let’s say DEF Corp. has generated a net income of $50,000 for the year. As the company has no preferred shares outstanding and has 5,000 weighted average shares on an annual basis, its earnings per share is $10.
50,000 ÷ 5,000＝ 10
In any EPS calculation, preferred dividends must be pared off from net income. That’s because earnings per share is primarily designed to calculate the net income for holders of common stock.
Additionally, in most EPS end-of-period calculations, a company is mostly likely to calculate EPS for end-of-year financial statements. That’s because companies may issue new stock or buy back existing shares of company stock.
In those instances, a weighted average of common stock shares is required for an accurate EPS assessment. (A weighted average of a company’s outstanding shares can provide more clarity because a fixed number at any given time may provide a false EPS outcome, as share prices can be volatile and change quickly on a day-to-day basis.)
The most commonly used EPS share model calculation is the “trailing 12 months” formula, which tracks a company’s earnings per share by totaling its EPS for the previous four quarters.
The Takeaway
Earnings trends, up or down, make earnings per share one of the most valuable metrics for assessing investments. Four or five years of positive EPS activity is considered an indicator that a company’s long-term financial prospects are robust and that its share growth should continue to rise.
A careful EPS calculation can help clarify a short- or long-term view of a company’s financial and share price potential, allowing an investor to make choices based on data and not assumptions.
Ready to put those stock-picking skills to use? Get started with SoFi Invest® today.
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Source: sofi.com
