When considering buying individual stocks, investors must do their fundamental analysis of a company to establish whether it’s a good buy or not.
The best place to start is to determine how the stock is valued, and one of the most popular and effective metrics to help make that judgment is earnings per share, known as EPS.
“We use a wide range of metrics to choose stocks, but EPS is one of the most important,” says Will Reese, director of equity research at UMB Bank in Kansas City, Missouri.
The main reason is earnings and stock prices are highly correlated. If corporate earnings or EPS increase, then the stock price generally goes up, Reese says.
If you’re deciding whether you should sell a stock, analyzing a stock’s EPS in conjunction with other metrics can be a guiding light. Consider the basic core elements of EPS to measure the financial stability of your stock holdings:
— What is earnings per share?
— How to calculate EPS.
— Why is EPS important?
What Is Earnings per Share?
Earnings per share is a valuation metric that is used to measure a company’s profitability. All companies that are publicly traded list EPS in their income statement, which provides the amount of earnings generated for each common stock share that has been issued.
What’s referred to as the basic EPS shows investors how much a business has earned from each share of stock owned.
Companies also publish diluted earnings per share, which assumes that in addition to common shares, convertible securities such as bonds or preferred stock, warrants or debt were applied. Its purpose is to also find the profitability of a company with the addition of the convertible securities to see how much corporate earnings have decreased.
This valuation metric can also give insight into the performance of a company’s fundamentals. Observing how EPS has changed over of a period of years can give shareholders perspective into the financial well-being of a company.
Watch Out for EPS Manipulation
Analysts pay close attention to EPS. It’s a metric that is highly weighted when valuing stock so institutional and retail investors alike review EPS with scrutiny.
EPS is a widely used metric because it’s easy to use and understand, which is why investors value the metric so much. For these reasons, experts recommend looking out for earnings manipulation because earnings are so important to the market’s view of a company.
Reese identifies earning manipulations by monitoring a firm’s revenue and cash flow profile.
If a company borrows money, repurchases shares, constantly cuts costs or removes products, then that can help drive EPS. And these earnings can be inflated, he says.
Investors should be looking to an EPS that is driven by improving fundamentals, Reese recommends, which can be seen through higher revenues, a new product launch or new geographic expansions.
How to Calculate EPS
Come earnings day, EPS is a calculation you want to focus on in order to understand the value of a company’s outstanding shares. Here is the simple EPS calculation:
EPS equals the company’s net profit minus preferred shares dividends divided by outstanding shares of common stock .
Preferred shares are excluded from this calculation since these shareholders get priority in dividend payments and payouts if there is a liquidation event, which common stock shareholders would be excluded from.
Diluted EPS equals the company’s net profit minus preferred shares dividends divided by the sum of outstanding shares of common stock and dilutive securities.
For example, Company ABC has $500 million in net income, $0 in preferred dividends, and 50 million shares outstanding. In that case, the $500 million in net income is divided by the 50 million shares outstanding. The result: Basic EPS is $10.
But let’s say Company XYZ has $500 million in net income, $5 million in preferred dividends, $4 million in stock options and 50 million shares outstanding. In this case, you would subtract the $5 million in preferred dividends from the $500 million in net income, then divide the amount by the sum of the 50 million shares outstanding with the 4 million in stock options. The diluted EPS is $9.17. Since Company XYZ holds convertible securities, its diluted EPS is less than its basic EPS.
One EPS figure by itself may not yield much insight. However, you can glean more about a company’s performance by looking at a five-year EPS trend or how a particular EPS stacks up against others in the same industry.
Trend movement is indicative of how the company has survived different types of economic cycles, says David Trainer, CEO of New Constructs, a research investment firm in Nashville, Tennessee.
“Understanding how companies have navigated the financial crisis is informative as to how they may navigate the pandemic,” he says.
If management has consistently grown earnings per share for many years, Trainer says that’s a good sign. “It gives you more faith that they’ll be able to perform well in the future. It’s not a guarantee , but it’s a nice track record,” he adds.
Experts recommend gathering as much of the company’s history as available, at a minimum of four to five years, to see how the EPS has changed. The higher the EPS or if the trend is increasing, the more profitable a company is. Conversely, if a company’s EPS has been decreasing, investors should investigate why this is the case.
Negative earnings per share mean the company has negative accounting profits.
Companies with negative earnings per share still have positive stock prices, Trainer says. “That tells us the market is forward-looking — it’s not looking at the current earnings but also future earnings.”
The stock’s valuation can be improved by convincing investors profits will be better in the future. “The way managers get their stock price to go up is by changing or improving investor expectations for future cash flows,” Trainer says.
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Why Is EPS Important?
Earnings are a vital component in a company’s valuation, which is why EPS is an important variable used in other ratio calculations. EPS is also used to determine the value of stock’s share price through the price-earnings ratio, where EPS is in the denominator. P/E equals the share price divided by EPS.
P/E is often used to determine whether a stock is undervalued or overvalued and is calculated by dividing the stock price by the EPS.
“A low relative P/E ratio may indicate that a stock is undervalued. However, a high relative P/E may indicate the company is overvalued. A faster growth rate of EPS would justify a higher P/E,” says David Kass, clinical professor of finance at the University of Maryland’s Robert H. Smith School of Business.
This result indicates how much investors are willing to pay for the company’s earnings. Evaluating a stock’s P/E can also help identify growth opportunities.
Also, a stock’s price to earnings to growth, or PEG ratio, is used to see if a stock’s value is undervalued or overvalued. The PEG ratio is P/E divided by the earnings growth rate.
The PEG is a better measure than just the P/E ratio to determine whether a stock is undervalued, fairly valued or overvalued, Kass says. “A lower relative PEG ratio may indicate a company is undervalued.”
These valuation ratios when reviewed together can be used to compare the value of other companies across industries. Investors can paint a full picture of a company’s valuation.
Reese says it’s important to identify what metric is important according to the industry you’re evaluating and that EPS is best used when applied to particular industries. “Within the health care, discretionary and technology sectors, EPS is extremely important because revenues are one of the most critical inputs.”
In other sectors like real estate or utilities, EPS might not be the main factor that drives valuation.
EPS is said to be stable when a company produces positive earnings.
“We measure a firm’s earnings stability by how well companies do during an economic downturn. Companies that can do well in downturns are the companies you want to invest in,” Reese says.
It’s important to have a comprehensive review of a company as you negotiate whether to add it to your portfolio of investments. EPS gives a glimpse into a company’s overall financial stability and helps investors gauge its value.
This is a living metric that should be a part of your valuation tool kit in evaluating your holdings. If the stock becomes a viable option, periodically review the EPS to make sure it stays along a positive trend.
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