When it comes to looking at a company's income sheet the answer almost everyone wants to know immediately is, "how much money did they make?" It does not matter how much of an increase in revenue, book value, or any other ratio there is ... if the earnings are low or non-existent the company share price will suffer severely over time.
Understanding earnings per share is one of the most important aspects of fundamental quantitative analysis and is the basis for numerous other ratios such as growth. If the EPS is growing over time this is positive. For instance, a company that dilutes its shares with offerings to institutions might be viewed negatively.
However, if despite the increase in shares the company can boost bottom line figures per share on a consistent basis, there might be wisdom in their process. Conversely, no matter what a company does that may seem smart, if the EPS is negatively impacted they should cease at once.
The business might be more interested in overall profits, but you the shareholder care about how much per share the company makes.
How is EPS or earnings per share calculated?
The Earnings Per Share Calculation
To arrive at the EPS you simply take the net income, subtract any dividends that are paid out, and divide this by the number of shares outstanding. If the company earned 500 dollars, paid no dividends and had 100 shares, the EPS would be 5 dollars. It does not take into account the current trading price. That will be discussed in the P/E or price to earnings ratio.
But this leads to other issues: what is considered net income and how many shares are outstanding? The answer could vary. A smart investor needs to know what he is looking at in order to base a trading judgment on it.
Outstanding Shares Can Vary
Share volume can vary by the amount that are currently issued up to the amount that could be present if all options and warrants were exercised. If the earnings are based on issued shares only this would be called Primary EPS. A Diluted EPS is based on the latter amount of all possible shares based on the derivatives. A diluted EPS is generally preferable since it is more conservative. Of course this number will fluctuate as options and warrants move in and out of the money making them able to be exercised or not.
Earnings Per Share Come in Different Flavors
There are many ways to report profits. Some might want to put a positive spin on the EPS and give a ratio that excludes certain expenditures. Or the EPS might seem low due to some one time deduction being included. Knowing what EPS you are looking at is vital to knowing if investor expectations were met or not. There are 4 types of EPS that we will be looking at:
- (GAAP) Reported EPS
In the SEC filing there is an EPS that is based on Generally Accepted Accounting Principles (GAAP). While this is the most common form of EPS reporting, be alert to the fact that one-time items can be added or deducted to modify numbers in the companies favor. The GAAP EPS needs to be looked over to ensure it fairly represents the expected operating of the business and does not include irregular items like a one-time sale or expenditure. - Ongoing or "Pro Forma" EPS
This type of EPS reporting attempts to differentiate between one-time expenses and revenue and the money made from the daily running of the business.
This type of EPS is important since it will tell the investor the true picture of how the core business is performing. A company could sell off its equipment and assets to boost GAAP EPS artificially, but the ongoing or "Pro Forma" EPS would highlight the real profits of the company. - Headline EPS
This is the number you will see spilled across the news and message boards. The media will generally spit out an EPS number without telling you if it is a GAAP or a "Pro Forma" number. - Cash EPS
This is an EPS reporting number that many like due to its pure form. It shows the company's ability to generate real dollars. Due to how the numbers are arrived at it makes manipulation of the report much more difficult.
Examples of operational cash flow would be short term investments, accounts receivable, and inventory. The operational cash flow is divided by the amount of diluted shares to arrive at how much hard money was earned per share.
Using EPS in Fundamental Analysis
Because EPS is the backbone of stock valuation we need to understand the type of EPS being reported and how to use it to determine growth. Once we know EPS we can graph it in a chart, use it to compute other ratios, and so forth.
For instance, a popular screening method for stock selection is to pick stocks that have annual growth of at least 20 to 30 percent. This high growth investing method helps one make sure they are not placing money in a worn out company that is just trying to maintain the status quo. Others will look for accelerated or increasing EPS. This means that three years ago the growth may have been 15 percent, two years ago it jumped to 20 percent, and last year saw an expansion of 25 percent. Increasing growth can lead to a runaway stock price as it builds pressure before finally achieving liftoff.
Analyzing EPS between quarters can also tell an investor much.
- Is the EPS consistent year round?
- Does the EPS have a large Christmas time boost in EPS?
Analyzing the EPS with each 3 month period will help you see which months they do the best business, if there are any anomalies that need investigating, or if this is a steady running growth company that continues to improve its bottom line each quarter for the past few years.
If we understand earnings per share, how it is derived, and how to analyze it, we are well on our way with fundamental quantitative analysis.