When one rushes into business, they need to know that they should have a set of skills to be successful. Courage to invest is one of them, but blind intuition has benefited no one.
Good investors use facts, indicators, tools, and measures to support their ideas and intuition. If we talk about stocks, in particular, Earnings Per Share (EPS) is a market ratio that everyone needs to understand and implement, and one of the most popular ratios in terms of stock valuation. How is it calculated? Why is it important? What’s the difference between P/E ratio and EPS?
What Is EPS?
Simply put, EPS is an indicator that shows how much a single share of a company has earned over a period of time. The first thing to know is how to calculate EPS. You can compute it if you have the following information: number of shares of common stock, net income and preferred dividend. The formula is:
EPS = Net income minus preferred dividend divided by the average number of shares.
In this equation, the numerator is the net income (less the preferred dividend). The denominator is the average number of common stock for a year.
Importance And Meaning Of EPS
The Earnings Per Share ratio is an important indicator that shows how much the profit of a company’s share is. Investors use it primarily to monitor the performance of a business over a long period of time. The number of shares constantly changes, which means that a company’s total earnings might not reflect the real profit equally.
Calculate the EPS: Example (1)
Let’s assume we work with Company Y and we have the following data:
- Net Income for the year is $10,000,000
- The preferred dividend during this period is $1,000,000
- The number of shares outstanding is 500,000
First we subtract the preferred dividend from the net income ($10,000,000-$1,000,000) and the result is $9,000,000. Then we divide this figure by the number of shares outstanding – $9,000,000/500,000=$18
The result shows that the earnings per share for company Y for the specified period is $18.
Calculate the EPS: Example (2)
Let’s take two companies: ABC and XYZ.
The first one had $25 million earnings in 2016. For the same year, XYZ registered $35 million. At first sight, investing in the second corporation is more profitable since they top the other one. However, let’s look at the number of their outstanding shares.
Company ABC has 5 million and the other one – 15 million. Simple math will show that a single share of the first company pays more than the second one.
What is “Perfect” EPS?
There is a general rule – the higher the EPS is, the better.
The result most likely reflects a well-performing company with sound and health management and financial discipline. It’s advisable to monitor other companies in the same sector and compare their EPS to the company you are planning to invest in. You can also find the company’s EPS year by year. This might show positive or negative trends you have to consider in your analysis.
Does EPS Have Any Limitations?
Normally, high EPS shows that a company is financially healthy and is a good investment. Nevertheless, this ratio does not consider other factors which might be a serious problem prior to investing.
For example, often companies buy their own stocks or reduce the number of outstanding shares in order to improve their performance. This eventually will result in a higher EPS without an actual increase in the company’s earnings. This is how corporations can trick investors into purchasing their stocks.
Two other factors which EPS does not consider are the company’s outstanding debt and the capital used to generate the profit.
For example, two companies have a similar EPS. However, one of them has used a considerably larger amount of funds to generate its earnings. This is a sign that the company does not manage its financial resources properly and probably investors should avoid.
Comparison Between P/E and EPS
A price-to-earnings ratio (P/E ratio) is another commonly used measure to compare the value of different stocks. If we want to compute this indicator, we need to know the EPS first. When you divide the price of a share by its EPS, you will have P/E ratio. You can use it to see the results of a single company during different periods or to compare two companies in a sector.
In a nutshell, price-to-earnings ratio (P/E ratio) is the amount of money an investor gets for one dollar of a company’s earnings. On the other hand, EPS shows the amount of money a single share of a company has earned. While the latter reveals the current situation of a company, the former shows the potential and how much are investors willing to pay for one dollar of a company.
Importance And Use Of P/E Ratio
High P/E ratio indicates that an outlook of a company’s future earnings is positive and investors believe that it will improve. On the other side of the coin, low P/E ratio shows that companies do not perform well or are undervalued. Sometimes companies have an N/A ratio which means that they have not generated any earnings (even losses) for the period. Usually, the P/E ratio cannot be negative.
There are two main types of P/E ratio – trailing P/E and forward P/E ratio. The first one takes into consideration the company’s earnings over the last 12 months, the reason it’s called trailing. Forward P/E ratio uses an expected EPS, for instance, this year or next year.
Sector P/E, Relative P/E, And PEG Ratio
When evaluating a stock, one should use all the measures and tools they can get: Sector P/E, Relative P/E, P/E to Earnings Growth.
- Sector P/E is used when you compare a company’s stock to other companies in the same sector. You also use an average P/E of the industry. This ratio will evaluate how the stock performs compared to its “peers”.
- Investors use Relative P/E to compare its current P/E to the ratio over a long period of time. This is how they can track the company’s performance and spot any lows or highs.
- The PEG Ratio examines the bond between current P/E and future (or past) earnings growth. We can calculate it if we divide the P/E ratio by the projected earnings growth. For example, a company’s P/E is 30 and the projected growth is 10%. The PEG ratio is 3 (30/10=3)
If you are an investor or someone who wants to get involved in this business, you have to start working with data and measures.
The EPS ratio, in particular, can help you when choosing a company and stocks to invest in. It will reveal how much a single share can earn in the future. Although EPS is an inseparable part of a company’s analysis, it’s not the only tool you have to take into account.
To have a broader picture, you need to consider other ratios and compare different companies within the same industry.