Fundamental Analysis: Understanding Earnings Per Share
The Most Important Metric in Fundamental Analysis Is EPS
Previously I did a series about using technical analysis for stocks, and now that I am going to begin one on fundamental analysis, there is no better place to start than with earning per share.
To the average person, a company's the top line number -- gross revenue -- is the barometer for success.
"XYZ made $850 gazillion dollars last quarter, they must be doing awesome," comes the cry.
But as an educated consumer, we know that it's not how much a company makes, but how much they keep -- their earnings -- that really matters.
However, as a smart stock market investor you have to drill down even further with your fundamental analysis when considering buying (or selling) a stock. And that leads you to the most important metric of all, Earning Per Share or EPS.
Earnings Per Share is calculated using the following formula;
(Net Income - Dividends on Preferred Stock) / Average Outstanding Shares = EPS
For example, say you have two companies, Company A and Company B.
Both of them had gross revenues of $500 million last year. But let's say that Company A had a net income of $100 million and Company B had a net income of $50 million. Your gut reaction might be to say that Company A is in better shape, and thus a better buy, than Company B.
But here is where earnings per share comes into play.
Let's say Company A has 50 million shares outstanding, but Company B only has 10 million. Using the EPS formula, and assuming neither company pays dividends, it would look like this;
($100,000,000 - $0) / 50 million shares = $2.00 per share
($50,000,000 - $0) / 10 million shares = $5.00 per share
So with Company A the earnings are two dollars per share, and with Company B the are earnings are five dollars per share. Based on the earnings per share, which company is doing better and which company would you be more likely to buy?
You can see why it makes sense to look at EPS as a comparison tool because it more fully shows the theoretical value per share that a company is worth, something you can't tell with just revenue numbers alone.
Obviously the earnings per share calculation is just a starting point in an overall fundamental analysis strategy, but it is one of the most important parts, one that other fundamental metrics are derived from.
There are even three different types of earnings per share numbers:
- Trailing EPS - Which uses the previous year's numbers and are considered the true EPS
- Current EPS - Using the current year's numbers, which since still in progress, are projections
- Forward EPS - Estimated EPS numbers for the following year(s) based upon the current trend
As you get more sophisticated in your fundamental analysis you can even start tracking the earnings per share of a company to see if they are increasing or decreasing, and if so at what rate, and use those numbers themselves in your analysis.
As I go deeper into this series on fundamental analysis I will be covering other earnings related topics like;
- Dividend Payout Ratio
- Book Value
- Return on Equity - ROE
- and more
Even if you use fundamentals, why not check out my series on technical analysis as well?
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