EPS, or earnings per share, is one of the most widely used metrics for fundamental stock analysis. This figure is reported quarterly by public companies and tracked closely by financial analysts.
But what does EPS really mean, and why is it so important for investors? In this guide, we’ll cover everything you need to know about EPS in stocks.
Back to Basics: Corporate Earnings
In order to understand EPS, it’s important to take a step back from the day-to-day fluctuations of stock prices. When you buy shares, what you’re really buying is a stake in a company’s future profits.
Those future profits yield returns for investors in the form of a dividend or share buyback. Alternatively, they might be re-invested in the company to drive growth, which in turn boosts expectations for more profits further down the road. Those future, larger profits can then be used to give investors an even greater return.
So, stock prices should directly reflect investors’ expectations for what a company will earn in the future.
What is EPS?
Aggregate corporate earnings are simple to track over time. However, the number of outstanding shares a company has can change over time and different companies have different numbers of outstanding shares. So, investors need to know how much profit companies are generating on a per-share basis in order to make meaningful comparisons over time or between companies.
That’s where EPS, or earnings per share, comes into play. EPS is simply a company’s net profits (after preferred dividends) divided by the current number of shares outstanding:
(Net profit – Preferred dividends) / Number of shares outstanding
This formulation offers what is known as a company’s basic EPS, but there are also more complex ways to calculate EPS. For example, diluted EPS divides net profits by the current number of shares outstanding plus the number of shares that could be released by employee stock options, warrants, and other convertible instruments.
Investors can also calculate EPS from continuing operations, which may be useful if a company is growing or shrinking. In this case, only income from divisions or locations of the company that will still be operating over the next quarter or the next year is counted towards net profit for the EPS calculation.
Why Does EPS Matter?
EPS matters to investors for two key reasons.
First, it’s a standardized way to measure how much profit a company is generating – regardless of whether that profit is distributed to shareholders immediately or re-invested in the company. EPS can be compared directly across companies, regardless of their size or how many shares they have outstanding. It can also be used to track whether a company is more or less profitable over time even as the number of shares outstanding changes.
Second, EPS can be used as a basis for determining how much value, on a per-share basis, investors are getting from a company. For example, EPS is commonly used to calculate a company’s P/E, or price-to-earnings per share, ratio. The P/E ratio offers information about how much investors are willing to pay for each dollar of earnings that a company’s shares provide. Often, the P/E ratio is used by fundamental investors to determine whether a company is overvalued or undervalued relative to its peers in the same market sector.
What Should You Look at When Analyzing EPS?
One of the main things to look at when analyzing a company’s EPS is whether it has grown or declined over time. This can provide information about whether, on a per-share basis, a company is bringing in more or less profits that can be paid out to investors or re-invested in the company. Typically, investors want to see strong EPS growth over time because this means that their return or potential future return is increasing.
Another thing to consider is the P/E ratio. The P/E ratio is most useful when it is compared against similar companies in the same market sector. In that case, it can provide information about whether shares of one company offer better value for your money than shares of another company. However, keep in mind that comparing P/E ratios assumes that all else is equal – in many cases, a company can have a higher P/E ratio because investors expect it to grow more in the future than its competitor.
It’s also important to keep in mind that while EPS enables you to compare earnings between companies, it leaves out information about how those two companies compare in size. If two companies have the same EPS, but one has far fewer assets, the smaller company is using its assets much more efficiently to generate its return on investment.
In addition, investors should be aware that EPS isn’t everything. For stocks that don’t pay a dividend, the link between EPS and share price can be tenuous since investors don’t actually have access to the company’s earnings. Be sure to look at a wide range of fundamental factors, including total valuation, projected growth, and cash flow when considering investing in a stock.
EPS is an important fundamental metric that provides information about a company’s earnings. EPS is comparable over time and across stocks, and it can offer insight into the market value of a company’s earnings when normalized to the stock price (the P/E ratio). However, investors should be careful to use EPS as just one factor out of many when considering what a stock is worth and whether it is overvalued or undervalued.
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