Earnings per share (EPS) is one of the simplest and most valuable metrics for day traders. Many traders credit EPS as their secret weapon to figuring out the best stocks to trade.
Earnings per share is a common phrase in the world of day trading, but few actually have a grasp on what it means. Unfortunately, a lack of knowledge about EPS and its ramifications can keep you from making educated decisions in your stock picks.
Learning about EPS can help you gain insight about stocks and help you determine if a trade is worth your time. It’s a good idea to get acquainted with EPS as part of your fundamental analysis and as an overall means to improve your trading.
Here, I’ll explain what EPS is, why it matters, and how it can affect your trading career.
What is Earnings Per Share?
Earnings per share refers to the portion of a company’s profits that are allocated to every outstanding share of stock.
If that sounds confusing, don’t worry — once you break it down, EPS is easy to understand.
Basically, the ratio of earnings per share is a measurement of the net income (the bottom line, after expenses) of a given company that is, in theory, available to pay stockholders of its common stock.
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Importance of Earnings Per Share
Why does earnings per share matter? There are a number of reasons why it’s worth considering as a standard part of your stock research, including:
Pricing of shares. The EPS ratio is a strong variable in determining the price of the shares of a given stock. It can help you understand why a stock’s price is at a certain level.
P/E ratio, EPS is an important factor in calculating the price-to-earnings ratio (also referred to as the P/E ratio). Here’s a good definition of P/E ratio. The earnings referred to in that ratio are the same E from EPS, by the way. By using this ratio, you can better understand the market value of a stock based on the company’s earnings.
Valuing a company. The EPS helps determine the value of a company, because it divides the profits into tidy little per-share units. It’s neat, clean, and easy to understand.
Since the amount of outstanding shares could change, simply looking at a company’s overall income may not be the best indicator of a company’s potential to offer profits to a trader. The EPS offers an additional way of looking at the company’s overall wellness.
Let’s put that in a hypothetical example. Say that Company X had a huge earnings increase this year. On the surface, this might seem like amazing news to an investor. More money is good! Obviously it’s a good idea to buy, right?
Not so fast. Even if the earnings have increased, if the total shares haven’t gone up in kind and the EPS hasn’t increased dramatically, it might not add up to the huge windfall you’re hoping for as the investor. In this way, the EPS provides a sort of checks and balances system.
Determining a company’s trajectory. What is a company’s history with EPS? If it’s trending in a positive way and has been over time, then this is a positive sign of potential profitability.
It could also be an indication that the company will have sufficient funds to be able to reinvest some of its profits in future growth, which could lead to bigger returns for you, the investor.
However, if the EPS is trending negatively and has been over time, this could be an indication that the company is experiencing trouble. It could be a sign that there will be a reduction in the stock price in the future, which is obviously not desirable if you’re buying the stock.
Predicting future growth. As an investor, considering the EPS of a company’s stock can help you get a better idea of a company’s potential for delivering dividends in the future.
Looking at earnings per share and cross-referencing the company’s history of making changes to its dividends can give you a well-rounded look at what you might expect from the company in the future.
Of course, will never be 100 percent accurate, but it can certainly give you a better idea of what the future might hold.
What Does a Higher Earnings Per Share Mean?
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In general, if a company has a high EPS, it’s considered a good thing. Usually, investors see a high EPS as a sign that it has the capability to offer the following:
Potential for sizable dividends. A high EPS can be a good indication that the company will offer sizable dividends for investors.
In case you’re not clear on what a dividend is, it’s the distribution of the company’s earnings to a class of its shareholders.
Typically, the dividends are quoted on a per-share basis. For example, there might be a dividend of 25 cents per share. Or, there might be a percent-basis dividend, such as a 15 percent dividend yield.
You can read more about the different types of dividends in this post.
The company is committed to growth. Another benefit of a high EPS is that it’s an indication that the company will have the ability to reinvest the funds back into the business.
If the company is committed to promoting further growth, that’s often an attractive lure for investors. Because as the company grows, so does its earning potential.
Of course, there are many other factors to consider, such as the price of the stock, your account size, and so on. But by incorporating this in your research, you can begin to narrow down stock picks according to your account size and portfolio.
How to Calculate Earnings Per Share
Now that you have an understanding of the basic meaning and importance of earnings per share, let’s cover some of the nuts and bolts. How can you can figure out the EPS for a company whose stock you’re considering trading? Here’s what you need to know,
Compute the Number of Shares Outstanding
First, you need to figure out the number of shares outstanding.
The shares outstanding is the figure that includes all of the shares currently held between shareholders added to the blocks of shares held by investors. It also includes shares held by company insiders, such as employees and partners.
The shares outstanding is easy enough to compute. On a company’s balance sheet, you’ll see a section dedicated to shareholders’ equity. While it depends on the balance sheet, it’s usually at the bottom of the document.
You’ll see line items for preferred stock, common stock, and sometimes treasury stock. These line items will each include the shares outstanding.
All you need to do is add together the shares outstanding for the preferred and common stock, and if applicable, subtract the amount listed under treasury stock. Just like that, you’ve calculated the shares outstanding. Boom. Pat yourself on the back.
Weigh the Shares Outstanding
Sometimes things occur during a reporting period that can throw off the number of shares outstanding. For instance, if a stock splits or if more shares are issued for any reason, it can throw off the calculation.
As such, calculating the weighted average of shares outstanding can sometimes give you a more accurate idea of the shares overstanding over a period of time.
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Sum Up to Compute the Weighted Average Number
To figure out the weighted average number of shares outstanding, take the number of outstanding shares, then multiply the time of the reporting period during which those shares were active (for instance, six months of the year would be 0.5).
Then, add up the different sums, and you’ll have the weighted average number.
2,000 shares outstanding (2,000) times the first six months (0.5) of the year = 1,000
2,500 shares outstanding (2,500) times the second six months (0.5) of the year = 1,250
Weighted average: 2,250
Earnings Per Share (EPS) Formula
Now that you have the weighted average of shares outstanding, it’s EPS time. Here are two basic formulas to calculate the EPS.
Net Income / Total Number of Shares Outstanding = Earnings Per Share
Net Income / Weighted Average of Shares Outstanding = Earnings Per Share
Either of these formulas can be used to compute the EPS. However, many investors prefer the latter because it helps balance out fluctuations over time.
Since the weighted average number can help account for changes in the amount of shares outstanding, it may prove more accurate as a calculation.
Earnings Per Share Analysis
When working with a company’s EPS, you shouldn’t just compute a number, look at how high it is, and call it good. There are things to consider when analyzing the EPS. Keep these points in mind.
You must consider the capital. An often-ignored aspect of EPS is the money necessary to generate the net income or earnings in the calculations.
For example, say that you have figured out the EPS for both Company Y and Company X. Both companies come up with the same EPS number. This doesn’t necessarily mean the companies are equal, though.
The thing is, both companies might not be operating with the same amount of equity. The company that is operating with better margins to generate income could prove a smarter investment.
Earnings manipulation: Be sure to read the fine print. Do some research on the earnings reports and analyze the statements. Don’t rely on just one source to determine the financial health of a company and its stock.
As readers of this blog and my students know, I’m all about research. I’m often distrustful — and for a very good reason. There’s profuse false information out there, and a plethora of shady, dishonest people.
Always do your research. It’s a good trader habit to adopt now and maintain for life. Yes, it will take a little time, but if you discover something that can help keep you from losing money, it was well worth the effort.
Basic vs. diluted EPS. In using the above formulas, you’re determining the basic EPS of a company. However, this doesn’t take into account how additional securities such as stock options, warrants, and so on can have a diluting effect.
These things could increase the overall number of outstanding shares. To get a full picture on a company, be sure to look for the diluted EPS too. This can help you get a more realistic view of what could happen if these additional securities were exercised.
The more aspects of the EPS you can consider, the more realistic an idea of the company’s status you’ll be able to gain. Here’s a little more explanation on basic versus diluted EPS.
Basic Earnings Per Share
Often, when referring to the EPS, you’re actually referring to the basic EPS. This calculation doesn’t take into account factors such as preferred shares, stock options, and more.
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Diluted Earnings Per Share
The diluted EPS takes into account the factors listed above, which can have the effect of diluting the stock. Some say that the diluted earnings per share offers a more realistic look at the company.
Earnings Per Share Example
To help you better understand these calculations, let me lay out an example. Say that Company X had a total income of $10 million during a fiscal year, while maintaining a weighted average of 20 million shares.
To calculate their EPS for that time period, you’d divide the net income by the number of shares.
So your calculation might look like this:
$10 million divided by 20 million shares = $0.50
Different Types of EPS
Basic versus diluted aren’t the only types of EPS calculations that you should consider. Responsible traders also take into account the variations on the EPS based on different time periods.
The trailing EPS, the current EPS, and the forward EPS are all different calculations which can allow potential investors to consider the past, present, and future in their research. Let’s take a deeper dive here.
Examining a company’s past can be a good indication of what the future may hold. The trailing EPS is a company’s EPS from a time period that has already passed. Usually, it’s most relevant to look at the most recent year on the books.
While many factors can change a company’s EPS over time, looking at its trailing EPS does offer some advantages.
For one thing, it’s based on cold, hard, factual data. It’s calculated using actual numbers from the company’s earnings and history. This means that it gives you a realistic look at how the company has performed in the past.
The trailing EPS, when considered along with the current and forward EPS, can help you make a reasonably solid decision about whether an investment is a good choice for you.
The current EPS is a mix of some data and some conjecture. Basically, it’s a projection of the EPS for the current year. You calculate the data for the time that has already transpired in the fiscal year, combined with projections for the remainder of the year.
Because it does mix actual data with projection, the current EPS gives you a pretty good idea of how the EPS may shape up for the year.
However, it should never be seen as a factual number, because things can change. It’s worth considering as part of your research, but don’t let the current EPS be a deciding factor.
Is a stock’s future bright? That’s what a forward EPS ideally indicates. A forward EPS is an estimate for the future, based on either company or analyst-generated estimates.
The forward EPS is interesting to look at, but it’s important to remember that it is based on projections, not facts. So while it’s not a waste of time to consider the forward EPS, don’t use it as your sole source of deciding whether to invest in a stock.
Learn How to Increase Earnings Per Share
How does the EPS increase? There are a few key ways, including an increase in the company’s revenue or the company lowering its costs (also called margin expansion).
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Another method of increasing EPS is via share buybacks, where the company effectively lowers the amount of available shares without changing its profits. When the lower share amount is plugged into the EPS calculation, it increases the total amount.
Effect of Stock Dividends & Stock Splits on Earnings Per Share
When a stock splits, the total number of shares is increased. This affects the EPS because it affects the total number of shares outstanding, which changes the calculation in the ratio. So the EPS is affected in direct relation to how many more shares were added.
However, this doesn’t mean it’s time to panic. Since the company’s value and profit doesn’t change, the P/E ratio doesn’t change.
So if you’re researching a company’s earnings and you see a dramatic and sudden drop in the EPS amount, it could simply be due to a stock split.
Be sure to back this up by researching that there were, indeed, a large amount of shares added. Then be sure to use the weighted average formula for calculating the most accurate EPS ratio.
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Learning about the earnings-per-share ratio can help improve your stock market prowess.
Calculating a company’s EPS can give you valuable insight about the company’s health. It’s also helpful to consider a stock’s past and potential future.
Bottom line: Incorporating EPS calculations in your repertoire can help you make more calculated and tactical decisions in your investments, and considering a company’s EPS in your stock research can help you become a stronger trader.
Do you use the EPS in your research?