Fundamental Analysis: Understanding Earnings Per Share
The Most Important Metric in Fundamental Analysis Is EPS
To the average person, a company's gross revenue is the barometer for success, but 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, earnings per share (EPS).
A company's EPS is calculated using the following formula:
(Net Income - Dividends on Preferred Stock) ÷ Average Outstanding Shares
For example, say you have two companies, Company A and Company B, that both had gross revenues of $500 million last year. If 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 a better buy than Company B, but here is where EPS come 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
With Company A, the earnings are $2 per share, and with Company B, the are earnings are $5 per share. Based on the EPS, Company B is by far the better choice. This is 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.
The EPS 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 EPS numbers:
- Trailing EPS: Uses the previous year's numbers and is considered the true EPS.
- Current EPS: Uses the current year's numbers, but 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 start tracking the EPS of a company to see if they are increasing or decreasing, and if so, at what rate.
Other Earnings Related Measures
- Price to Earnings Ratio (P/E): The ratio of a company's share price compared to its EPS.
- Projected Earning Growth (PEG): A stock's P/E ratio divided its the growth rate of its earnings.
- Price to Sales (P/S): A company's market capitalization divided by its total sales for the year.
- Price to Book (P/B): A company's stock price divided by its book value per share.
- Dividend Payout Ratio: The amount of dividends paid out to shareholders relative to the company's income.
- Book Value: The value of an asset that's on a company's books.
- Return on Equity (ROE): The profitability of a business relative to its equity.