Understanding EPS: A Comprehensive Investment Guide

This beginner’s article will explain the basics of earnings per share (EPS).  It will show you how to calculate,  interpret, and use it in your investment decisions. It will also discuss the different types of EPS and the limitations and criticisms of this metric. By its end, you will have a better understanding of how to use it in your stock trading.

Understanding Earnings Per Share

EPS is a financial metric showing a company’s profitability and value. You calculate it by dividing the company’s net income by the total number of outstanding shares. The formula for its calculation is:

EPS} = Net Income/Number of Outstanding Shares

Net income is the company’s total net profit, and outstanding shares are the total number of shares investors hold. EPS’s direct relationship with  a company’s profitability makes it a valuable tool for analyzing its financial performance.

Example of EPS Calculation 

Let’s use the Amazon stock, ticker symbol AMZN, to show how you can determine its EPS practically. By the close of 2023, the giant retailer had 10.322 billion outstanding shares. The company also reported a net profit of $30.4 billion.

Using the EPS formula, we realize:

Earnings per share = $30.4B / 10.322B shares

        =  $ 2.945 per share

That means Amazon earns you nearly $3 in profit for every share you hold.

Types of EPS

There are several types of EPS’ each offering a slightly different perspective on a company’s profitability. Here’s a breakdown of the major types:

1. Basic EPS: This is the most commonly reported EPS and is calculated by dividing the company’s net income by the number of outstanding common shares during the period. 

2. Diluted EPS: Considers the potential impact of all dilutive securities like stock options, warrants, and convertible debt that stockholders could exercise, increasing the number of outstanding shares. It provides a more comprehensive picture of earnings per share

3. Pro Forma EPS: This EPS adjusts for non-recurring or unusual items that might distort the company’s core profitability. It aims to present a more normalized view of earnings, excluding one-time events.

4. Retained EPS: Focuses on the portion of earnings the company retains rather than what is distributed as dividends. It’s calculated by dividing the total retained earnings by the outstanding shares. 

5. Cash EPS: This measures earnings per share based on operating cash flow instead of net income. It can be helpful for companies with significant non-cash expenses or those focusing on cash generation.

6. Book Value EPS: This divides the company’s net assets by the number of outstanding shares to represent the theoretical value per share based on the company’s book value. It doesn’t consider profitability but can help compare companies with different capital structures.

Interpreting Earnings Per Share

With the basics of EPS out of the way, let’s shift our focus to its interpretation. Here’s a breakdown of what that figure means:

• High EPS: Generally indicates high profitability and the company having a competitive edge. Investors may view the company as more valuable and may be willing to pay a higher stock price.
• Low EPS: A low EPS points to lower profitability or the company lacking a competitive advantage. It doesn’t necessarily mean the company is bad, but it calls for further analysis.
• Negative EPS: This one signals that the company made a loss and could be facing financial headwinds. It could also result from restructuring, a vast one-off expenditure, or a significant setback in its performance.
• EPS Trends: An upward trend reveals the company is improving its profitability. Meanwhile, a decline or fluctuating trend suggests the company is struggling to remain viable.

Using EPS in Stock Trading

EPS is pivotal to understanding a company’s financial health and investment potential. So, here are a few ways of incorporating it into your stock investments:

Comparing Company Performance:

Dividing a company’s net profit by its outstanding shares gives you a standardized metric reflecting the profit each share generates. This is useful when comparing companies in the same industry.

Tracking Financial Progress:

Monitoring a company’s EPS over time can reveal trends in its profitability. A steady increase shows it is using its resources effectively and generating more profit for the shareholders. Conversely, a decline indicates potential financial woes.

Estimating Corporate Value:

Investors often use EPS with other metrics, like the price-to-earnings (P/E) ratio, to estimate a company’s intrinsic value. A higher EPS and a reasonable P/E ratio can indicate an undervalued stock and a potentially good investment opportunity.

Dividend Potential:

Companies with consistently high EPS are more likely to pay higher dividends. So, a strong EPS track record can be a positive sign for value investors.

Limitations and Criticisms of Earnings Per Share

While EPS offers valuable insights, it has its limitations and criticisms. Below is a glimpse of its major drawbacks.

• EPS neglects non-cash expenses like depreciation, distorting a company’s profit picture.
• It focuses on historical data and may miss crucial information about future growth prospects.
• Comparing EPS across industries with vastly different profit margins and business models can be misleading. 
• Unethical companies can manipulate their numbers to inflate their EPS, impacting reliability. 
• It assumes the company’s debt levels or financial risks, which can significantly impact its overall financial health. 
• While EPS reflects profitability, it doesn’t directly translate to actual cash flow, which is crucial for a company’s viability. 

Conclusion

Earnings per share is a powerful stock analysis benchmark. But it is just one of the many you can use to boost your stock trading. Consider using it with other metrics and technical indicators before making investment decisions. With this knowledge, you’ll be well-equipped to confidently navigate the stock market, making informed choices for your investment goals.

FAQs

What is EPS?

EPS measures a company’s profit from each outstanding share of its common stock.

Why is EPS important?

EPS helps investors assess a company’s financial health and profitability.

What is a good EPS per share?

There’s no one-size-fits-all answer to this question. A “good” EPS depends on various factors, including industry norms, company size, and growth expectations.

What is the Basic EPS Formula?

The basic EPS formula is:

Basic EPS = Net Income / Outstanding Shares

What is the relationship between EPS and Stock Price?

There’s a direct relationship between EPS and stock price. As such, increasing EPS typically increases the stock price and vice versa.