Time for the second installment of our metric of the week. This week, my friend John will talk about earnings per share. This is one of the core metrics that every investor should know. Last week we looked at the P/E Ratio, which is arguably the most fundamental. John is a law student who loves following and learning about the markets, so I’m glad to have his help here.
Metric of the Week: Earnings Per Share
Earnings per share (EPS). Seems pretty self explanatory right? It’s the earnings of a company divided by the number of shares outstanding. So, if Company A has an EPS of $6.00 and Company B has an EPS of $8.00, Company B is the better performing company right? Not so fast. Earnings per share can be one of the more misleading metrics because you always have to take into account how many shares a company has outstanding and the method that is used in calculating the EPS.
First we’ll figure out how to calculate EPS. Here’s the formula that is given on Investopedia for the calculation of EPS:
Net Income – Dividends on Preferred Stock
Weighted Average Number of Shares Outstanding
Some sources will subtract the dividends of preferred stock, while others will include it in the numerator. The reason for this is that these earnings are not available to common shareholders. As an aside, when most people talk about net income or earnings per share or similar metrics, they are referring to ones available only to common shareholders. In this specific example, preferred shareholders will receive their dividends in full before any dividends could be paid to common shareholders. Usually, however, the preferred shareholder base is quite small.
With respect to net income, most finance sites like Yahoo! Finance will use the trailing twelve months (TTM) net income for their calculations. Curious to see how this works? Here’s a sample calculation for Visa (V) from Yahoo! Finance data:
2.97B (Net Income available to common shareholders)
716,620,000 (number of shares outstanding)
EPS = 4.14
We arrive at an EPS of 4.14. This is really close to the 4.15 that Yahoo has in its data for Visa. This tiny difference is most likely due to a change in the number of shares outstanding at the time of their calculation or a different net income calculation or it could be a simple rounding error. In general, if you don’t trust the numbers on Yahoo! or Aol, then you could easily calculate EPS yourself, but the number they give you are usually pretty close to what you will calculate yourself.
Now, for the important stuff. How do you use EPS? As I mentioned before, EPS is not a good metric to compare different companies. This is because companies all have different share prices. Take for example, Goldman Sachs (GS) and JPMorgan (JPM). Both are quite profitable. JPM has an EPS of 3.97, while GS has an astronomical EPS of 13.17 (both according to Google Finance on 1.26.11). However, despite this disparity, you can’t really compare them apples-to-apples. GS has a share price hovering around 161, while JPM is sitting at about 45. Thus, it’s not quite as useful in relative valuation as is the P/E Ratio.
EPS, however, is a good metric to measure a company’s current performance to its past performance, as long as you make sure that the number of shares outstanding has not changed. If there has been a stock split, an issuance of new stock, or a share buyback, the number of shares outstanding will change, thus altering the company’s EPS. When the number of shares outstanding stays constant, EPS is a great way of monitoring a company’s performance through time. Read any company earnings report, and you will see how often company managers and investment analysts refer to EPS as an indicator of company performance through time.
The bottom line is EPS is just one part of an investment research strategy. Like P/E, EPS can be an indicator that something is wrong with the company, and should alert you that more research is needed. If EPS seems relatively consistent with expectations, then you can use it as an argument in support of an investment decision. As we always emphasize at Investing Part Time, detailed research should be undertaken before making any investment decision.
From now, the plan is to build from the most common metrics you’ll come across progressing to some of the more advanced, obscure metrics that are more industry specific. If you’ve heard about something and want it to be explained in the Metrics of the Week, just leave a note in the comments and I’ll be happy to include it in a later post.
Disclosure: At the time of publishing, I hold a position in GS, but no other companies mentioned above. Positions may change at any time.