The earnings per share (EPS) of a company is one of those important little numbers that every investor should know about a stock before investing in it. It’s a telling way of looking at a company’s profits because it takes into account the number of hands in the pie, or the number of shares on issue.
The market likes companies that post big earnings numbers, and is particularly fond of stocks that report high EPS. The formal definition of EPS is:
Earnings per Share = Net Earnings After Tax / Number of Ordinary Shares
A company with $1 million in earnings and 500,000 outstanding shares, its EPS will be $2 ($1 million/500,000).
The higher the EPS of a company, the higher each share should be worth. For this reason, company analysts will track a company’s EPS for a positive trend. They want to see EPS growing over a five-year period. They’ll also compare the EPS of a stock to its peers and the sector average.
EPS is so closely tracked by company analysts and investors that company executives have been known to link bonuses and other remuneration to an EPS target. Strong growth in a company’s EPS will match the number of luxury cars in the CEO’s garage.
Share buybacks (buying back shares from shareholders) can artificially boost the EPS of a stock since it reduces the number of shares on issue. A CEO, whose salary is linked to EPS growth, might engage in a share buyback as a way to prop up the EPS. Clearly this isn’t a sound long-term strategy for a company, and investors should be rightly critical.
On the flipside, capital raisings from issuing new shares – rights issues, institutional placements, bonus shares and the like – cause a dilution in equity because the earnings of the company have to be divided by more shares. Capital raisings are bad news for EPS, and often the share price will sink accordingly.
So if a stock clocks a higher EPS than another stock in the same industry, is it a better buy?
Let’s think about this; a higher EPS could be due to:
1. Higher earnings (numerator in the ratio above)
2. Lower number of shares on issue (denominator in the ratio above)
Indeed, two companies could post the same earnings but if one stock has less shares on issue than the other, its EPS will be higher. (As a quick example; Company A and Company B pulled in $1 million from selling dishwashers, but Company A had 200,000 shares outstanding whereas Company B had 100,000. The EPS for Company A is 5 and the EPS for Company B is 10). Since it clocked a higher EPS, is Company B therefore a better buy than Company A?
It could be said that Company B is a better company than Company A because it’s more efficient at using its capital to generate profits; it makes the same level of profits with less equity investment.
But the share prices of Company A and Company B will not necessarily reflect their respective EPS. Indeed, you may find that Company A sports a higher share price than Company B due to its rosier outlook over the longer term.