Why is EPS Important to Investors?

Understanding EPS

Earnings per Share or EPS is the portion of a company’s profit that is allocated to each individual outstanding share.

Many times the question that investors have in mind is “In what way EPS is useful to me as an investor?”. We will try to answer that question today.

Why is EPS Important to Investors?

EPS is an important metric for an investor due to following reasons:

A Measure of Profitability

Earnings per share as a metric is extremely important to measure company’s profitability. In fact, in the entire subject of fundamental analysis, EPS is the only metric that isolates net income to find out what the shareholders are gaining by investing in the company. As a layman, we understand that a company is in the market to do business & make profits and the investors invest in companies to be a part of company’s profitability. A consistently growing EPS means that the investor is getting a share of company’s growing profits consistently. Growing EPS also indicates that the company is creating value for its investors. In contrast, a consistently falling EPS or negative EPS indicates financial trouble, low profitability or consistent losses, & eroding investor value.

EPS answer two primary questions for the investors. First is “how much profit per outstanding share does a company make?” and the second is “how much profit is accrued to a shareholder?”

An Indicator of Dividend Payout

Dividends are a portion of company’s profits that is distributed to the shareholders. Many investors like the steady income associated with the dividends. Investors also view dividends as positive sign & strong growth in future for the company. The company can only give dividend if it has excess earnings per share. Even though dividend payout is not directly related to EPS, it is commonly seen that only those companies that have consistently stable or growing EPS, pays dividends to its shareholders. Though dividends are very subjective & a lot of things are considered before dividend payout, investors who are looking for dividend income should look at company’s EPS before investing.

Importance of EPS to Investors

A Determinant of P/E ratio

Beyond profitability, investors are interested in knowing the value that a particular share brings to their portfolio. P/E ratio can help investors in valuing the shareholding. The key determinant of P/E ratio is EPS.

P/E ratio = Price per Equity Share/ Earnings per Share (EPS)

Let’s understand how EPS is important to this metric. Suppose company A has one equity share priced at USD 100 and it EPS for the year 2017 is USD 20. So its P/E ratio will be 100/20 = 5, this means at current profitability it will take 5 years for the company to earn its market price per equity share. In other words, investors will have to be invested in the company for 5 years to recover their investment. Now let’s take company B, its market price per equity share is USD 1000 & its EPS is USD 100, so its P/E ratio will be 1000/100 = 10. Which means the investors will have to stay invested for 10 years to recover their investment in the company.

Had we looked at the EPS alone company B looks better at EPS of USD 100 than company A that has EPS of USD 20. But looking at P/E ratio, company A looks much better bet at much faster return on investment.

Key Takeaway

Earnings per share is a common financial ratio. It is very easily accessible to investors as the company gives EPS figure on its annual reports. It is also usually the first ratio that investors look at because of its ease of understanding and indication of profitability. Despite its simplicity ESP as a metric is extremely powerful and concentrates crucial information in a single number. It allows investors to compare investments across sectors, industries and to an extent also with alternative investments. It also helps to chart the financial performance of a particular company over time. This helps investors to make informed decisions. Though one must do a complete fundamental and market analysis before investing in a company, we can say that EPS as a metric by itself is also quite telling about the profitability & value of the company and can give investors a head start to sort the profitable companies from the nonprofitable ones.

Reference

BOOKS:

  • Financial Reporting & Analysis, CFA level 1, CFA Institute
Last updated on : May 17th, 2018

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