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What Does EPS mean?
To arrive at earnings per share or EPS we must divide total profit by a total number of outstanding shares. Which means –
EPS = Net Profit / Total Number of Shares
EPS is an important tool in fundamental analysis & people often wonder “What is a good EPS for a particular company?” or “Is the EPS good enough?” These questions can be easily answered if we understand the logic behind EPS.
Let’s understand with an example –
Suppose we are analyzing two companies, Company X & Company Y. We have following information about them –
|COMPANY X||COMPANY Y|
|Total profit for the year 2017||USD 20.00||USD 100.00|
|Total number of shares outstanding||5 shares||50 shares|
|EPS||20/5 = USD 4.00 per share||100/50 = USD 2.00 per share|
You can also use Earnings Per Share Calculator for calculating EPS.
Now let’s ask the same question – Which company has a better EPS? If we just look at the EPS in isolation, we will say Company X has higher EPS so it is better. However, when we look at the whole picture, we can see that Company Y has higher earnings than Company X. So it is important to analyze further details such as the size of the company, how much revenue generated these earnings, etc. Only then we will be able to answer this question about which company has a better EPS.
Thus we can conclude that EPS is a relative measure, and it can’t be viewed in isolation. There are many factors that come into play when analyzing EPS. Some of the things to consider are as follows:
Perspectives in Evaluating EPS
A company’s historical data is important when assessing how good or bad an EPS is. A consistently rising EPS over the years is a positive sign, and it means the company is making good consistent growth. Whereas there is a drop in EPS, it is a cause of alarm for the investor. But again EPS should not be the only deciding factor for making investing decision. The fall in EPS, might be due to unusual or extraordinary events. It is important to analyze the reasons behind the fall.
Comparing with Peers & Industry Benchmark
It is always useful to compare each ratio of a firm with the ratio of its competitors & industry benchmark ratio. This is because companies within a sector or an industry will experience similar macroeconomic factors such as politics, economy, demographics, etc. So the chances of them performing similarly are very high. Like other ratios, when looking at EPS, it is good to compare a company’s EPS with its peers for a better perspective. For example, EPS of Apple Inc. is USD 9.27 per share, whereas industry benchmark is USD 6.45 per share. So we can conclude that Apple Inc. is doing well at least on this criteria.
Market Expectations of EPS
Before a company announces its result, analysts who follow the company or the sector try to predict the company’s results. It includes prediction of earnings as well as EPS.
If the company announces EPS that is equal to or higher than analyst prediction, then it is considered that company is doing well on EPS metric. If the actual result falls short of market prediction, the company will be viewed negatively, and company’s stock price suffers.
EPS & P/E Ratio
During financial analysis, an investor is trying to determine whether a stock is a good buy or not. EPS does not help in making this decision. This is because EPS doesn’t tell an investor if a stock is worth his money. This is where P/E ratio comes into the picture. P/E ratio attaches a company’s EPS with its market share price, so the investor would know if the stock is worth his money.
For example – let’s say that ABC Corporation has 100 million shares outstanding & it earned USD 200 million in profit over last one year. So ABC Corp’s EPS would be USD 2.00 per share (USD 200 million/ 100 million). But the question is “Is it worth investing money in ABC Corp for earning of USD 2.00 per share?”. Now let’s go one step further and say ABC Corporation’s stock price today is USD 50.00 per share. Then ABC Corporation has a P/E ratio of 25 (USD 50.00/ USD 2.00).
Before reaching any conclusion about whether a company’s EPS is good or bad it must be acknowledged that EPS is affected by many factors such as company’s accounting policy, share buybacks or share splits, mergers and acquisitions, etc. Furthermore, the EPS doesn’t convey anything about company’s financial health. For a value investor, just considering a company’s earnings is not sufficient. A company’s financial health is equally important for long-term profitability & value creation. Thus we can say that EPS is only one part of a big puzzle when it comes to financial analysis. The EPS may be good or bad, but it is important to consider other ratios and view the company holistically before making any investment decisions.
Reference:July 7th, 2018