Before you trade, it’s important to have a good understanding of the health of the company that’s offering the stock. Earnings per share (EPS) is a simple yet important metric that can help you gain insight into a company’s well-being.
Many traders recognize EPS from a ticker’s page on stock screeners, along with basics like the 52-week high and low. However, in spite of its ubiquity, few traders understand what EPS actually means.
In this post, you’ll learn what EPS is, why it matters, how it’s calculated, and how to use it to help inform your trading.
Table of Contents
- 1 What Is the Earnings Per Share Formula?
- 2 Three Steps to Calculate Earnings Per Share
- 3 Significance of Earnings Per Share
- 4 Conclusion
EPS is short for earnings per share. It’s pretty much what it sounds like: The portion of the company’s profits that are assigned to every outstanding share of stock.
Bear with me. I know it can sound confusing or technical. But it’s actually pretty simple once you break it down:
- The earnings per share formula measures a company’s net income (that’s the income after expenses) that’s available to pay common stock shareholders.
- The EPS is expressed as a ratio.
- This number can give you an indication of the company’s profitability.
Of course, it’s important to note that it’s normal for a company to adjust the EPS based on anomalies such as an extraordinary (and not likely repeatable) event or for potential share dilution.
How to Use EPS
OK … now you know what EPS is, so how is it useful to you in trading? Here are some easy-to-follow examples on how to use the EPS ratio:
Read between the lines. Here’s a hypothetical. Say that Company X just debuted the hottest new product of the year, and is experiencing huge, bigger-than-usual earnings. This is amazing! You should buy up as many shares as you possibly can, right?
Well, actually, maybe not. On the surface an earnings increase is great. But if the shares don’t go up and the EPS doesn’t increase in kind, this trade might not give you the return you’re hoping for. This is one way that the earnings per share can provide checks and balances, helping you to see the actual impact of sales increases on the company’s shares.
Determine future profitability. Fact: You can never know how a stock will perform in the future. But you can look at a stock’s past performance to get an idea of how it could perform in the future. A company with an EPS that increases positively over time can indicate the potential for future profitability.
Increasingly high EPS numbers could also be a good indicator that the company in question has enough money to invest some of its profits in future growth. This could mean bigger returns for you in the future.
Sniff out company trouble. On the flip side, if an EPS trends downward over time, this could signal that the company’s in trouble. It might be a sign of a lowered stock price in the future. That might be bad if you want to go long, but it could be of great interest if you want to go short. It’s a matter of how you trade.
Scope out future dividend potential. The EPS can help you get a better idea of what kind of dividends you might expect from a company. Here you want to check out the EPS and the company’s history of dividends to project the potential for future dividends.
Of course, you should never execute a trade based on any one of these considerations — or any single indicator, ever. This is just more information you can use to understand a bigger picture of a stock’s potential.
So now you know a bit more about the EPS ratio, but you still don’t know how to calculate it. How can you calculate this seemingly magical little ratio?
Not gonna lie, the easy way is to let something or someone else do it for you. While it’s good to understand how EPS is calculated, you don’t actually need to do it yourself.
It’s never a bad idea to look at a company’s stats. And knowing how to calculate earnings per share can give you a better understanding of how it works. Let’s discuss how to do it …
This calculation is for what’s referred to as the basic earnings per share. This is the simplest and most common calculation for EPS. Important note here: This calculation doesn’t take into account factors such as preferred shares or stock options.
The first step to calculating the EPS is to determine the number of shares outstanding.
Shares outstanding is the number of shares held by shareholders and also the blocks of shares held by investors and company insiders (employees, partners, etc.). Look for the shares outstanding on a company’s balance sheet in a section for shareholders equity. It’s usually at the bottom of the doc.
This is where you’ll find line items for preferred stock, common stock, and (sometimes) treasury stock. Each of these lines will include shares outstanding.
That’s it! You just calculated shares outstanding.
So, what if a stock splits or if a company issues additional shares, for whatever reason? That can throw off the calculation and yield confusing results. If you know about such an event, you need to determine the weighted average of the number of shares outstanding. This can give you a better idea of the shares outstanding over time.
Let’s look at an example. Say that at the beginning of the year, a company had 1,000 shares outstanding. Then, later in the year, they issued an additional 500 shares.
To calculate the weighted average of the shares outstanding, do this:
Multiply the number of outstanding shares by the amount of time of the reporting period. In this example, that’s half of the year (or six months), which is 0.5.
Now, add up the different sums to get the weighted average.
- 1,000 Shares Outstanding times the First Six Months of the Year = 500
- 1,500 Shares Outstanding times the Second Six Months of the Year = 750
In this case, the weighted average is 1250.
Finally! It’s time to let the EPS ratio do its magic. There are two key formulas to calculate the EPS:
- Net Income divided by Total Number of Shares Outstanding = Earnings Per Share
- Net Income divided by Weighted Average of Shares Outstanding = Earnings Per Share
The first formula is easier but not necessarily better. Using the weighted average of shares outstanding is considered a good way to account for possible fluctuations over time.
What’s the significance of earnings per share, exactly? Here are some of the reasons why it’s important and the effect it can have:
- Share pricing. The EPS is a big part of determining the price of a stock’s shares. The EPS can give you a better idea of why a stock’s price is at the level it is. How? Well, The EPS is part of the equation (literally) when figuring out the P/E ratio (that’s price-to-earnings ratio, BTW). The P/E ratio refers to the relationship between the company’s stock price and the EPS. (FYI: The ‘e’ stands for earnings in both calculations.) This ratio can help you better understand the stock’s market value based on the company’s earnings.
- Valuing a company. EPS can help you build a view of the company’s overall value. It divides the profits into easy-to-understand per-share units. It can help you better understand the company’s value than if you simply looked at a company’s income. That’s because the number of outstanding shares can change, so just looking at the income alone might not give you the most accurate read on the stock’s potential.
Overall, the EPS gives you a way to look at the overall health and well-being of a company.
What Increases EPS?
Can the EPS ever go up? Yes indeed. Here are some things that could increase the EPS:
- An increase in company revenue.
- A reduction in operating costs, also referred to as ‘margin expansion.’
- Share buybacks. This is when the company lowers the number of available shares by buying them back (without a change in profits). The smaller number of shares can boost the EPS. Once again, another good reason to perform the weighted average of shares outstanding before calculating the EPS.
A word of caution: You should never consider the EPS your be-all, end-all cue for a trade.
For one thing, it’s unwise to make a decision just based on one indicator. For another, there are several important things to take into account when considering the EPS. Here are some of the limitations with EPS:
- What kind of capital is the company working with? In determining earnings per share, many neglect to consider the capital necessary on the company’s part to generate the net income. Here’s an example. Say that you have two companies with the exact same EPS. Does this mean that they’re equal? Nope. Just because they have the same EPS doesn’t mean that they have the same amount of equity. One company could have terrible margins, and the other might have great margins.
- Potential for manipulation. There are ways that companies can fiddle with shares outstanding to manipulate the EPS. So don’t just calculate the number and take it at its face value. Back it up with data. Research the earnings reports yourself — looking for anything that could throw off the EPS.
- Remember diluting factors. The EPS formula has its limitations. For example, it doesn’t account for things like stock options and warrants, which can potentially have a diluting effect. These things can increase the number of overall outstanding shares. So, to get a fuller picture on the company, be sure to look for the diluted EPS, too. Doing so can give you a more realistic idea of what might happen if a sudden event caused these options and warrants to be exercised. Ultimately, you need to look at the EPS from multiple angles and perspectives to help you work with a more comprehensive snapshot of the company.
You just read a lot of words regarding EPS. Feeling overwhelmed? Let’s step back a bit and simplify things.
You also need to remember that the EPS is only one piece of the puzzle. Think about a procedural police drama where detectives are chasing down a suspect. They can’t just arrest a criminal on a hunch. They build their case by interviewing people, doing research, surveillance, etc.
Never trade based on just one indicator. Think like an investigator. Look at a mix of news, fundamentals, technical indicators, and charts. You want to feel informed and educated before you risk a single cent. Think about what’s at stake.
Take Advantage of StocksToTrade Features
EPS factors prominently into each ticker’s page, and automatically displays whenever you open a new stock tab, along with basics like the daily high and low, volume, and market cap.
Of course, the platform is highly customizable, so you can tailor these settings to your preferences. But it’s there when you need it!
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If you want to be an informed and educated trader, it’s important to gather as much information about a company as possible. The EPS can be a valuable part of your research.
By learning about the EPS formula and what it means, you can improve your stock market know-how and gain insight into a company and its stock.
Incorporating the EPS formula into your trading research routine can help you in building stronger watchlists and making more well-rounded decisions about stocks to trade.
How do you use the EPS when choosing stocks? Leave a comment and let me know your thoughts!