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Ratio Analysis: Earnings Per Share

Few ratios or financial ideas are better known than earnings per share, or "EPS," the figure that tells us how much profit we've earned (or not) on each share of our investments.

Still, there are some aspects of the measure that some investors may not know, and Axel Tracy set out to fill those blanks in his 2012 book, "Ratio Analysis Fundamentals: How 17 Financial Ratios Can Allow You to Analyse Any Business on the Planet."


First, the author noted that earnings per share is a valuation ratio, which is to say it is one that investors use when they are trying to establish how much a company is worth. He explained: "Owners indirectly buy the earnings potential of a business when they purchase stock, thus this ratio (based on earnings) can have a direct influence on what one would pay for each share."

Earnings per share has the virtue of being comparable across all industries and stock markets, making it useful for comparing the earnings power of different companies, even if they operate in widely different industries. Investors invest in companies in the expectation of earning a profit and this ratio offers an immediate answer to how well the company is doing.

Tracy added that earnings per share can have a direct influence on how much investors will pay for stocks. While that may not be a 100% direct influence, there is an alignment between higher earnings per share and higher stock prices--and vice versa.

The earnings per share ratio is calculated with this formula:


"Earnings per Share (EPS) = (Net Income - Preference Dividends) / Weighted Average Number of Common Shares Outstanding"



For example, a company has:

  • Net income of $10 million.
  • Preference (preferred) dividends of $1 million.
  • 20 million shares (weighted average number of shares outstanding).



Therefore, it has an earnings per share ratio of ($10 million - $1 million) / 20 million = $0.45 per share. Data for the calculation comes from the income statement (net profit and preference dividends) and from the notes to the financial statements (weighted average number of common shares outstanding).

GuruFocus users will find a close equivalent to earnings per share in the profitability section of the summary pages. Rather than just simple EPS, it uses the "3-Year EPS without NRI Growth Rate" (which will be explained below). As an example, here it is at the bottom of the Apple (NASDAQ:AAPL) summary page:

Why this elaborate version of earnings per share? GuruFocus provided this explanation:


"Earnings Per Share (EPS) is the single most important variable used by Wall Street in determining the earnings power of a company. But investors need to be aware that Earnings per Share can be easily manipulated by adjusting depreciation and amortization rate or non-recurring items. That's why GuruFocus lists Earnings per share without Non-Recurring Items, which better reflects the company's underlying performance."



A related version of earnings per share is shown just above the EPS ratio: "3-Year EBITDA Growth Rate"; this latter ratio obviously refers to earnings before interest, taxes, depreciation and amortization.

As for "growth rate," how quickly a company is growing, or not growing, is the most commonly sought-after information. In Apple's case, the growth rate has been robust since about 2005, as shown on the page dedicated to comparing its results with those of its competitors and its own history:

Bear in mind that in using the three-year earnings per share without non-recurring items growth rate, GuruFocus generates a percentage (for rate of growth), while regular earnings per share figures are in absolute numbers, dollars and cents.

In the example above, we saw a company earning 45 cents per share, which means that owners (shareholders) received 45 cents for each share they owned. Is that a good result? The book doesn't cover this aspect, but that amount, by itself, tells us very little. We need to know how much was paid for each share.

If an investor receives 45 cents on a share that cost $4.50, then it would be a 10% profit. Had the investor paid $9 per share, then it would a 5% profit. Obviously, a 10% profit is better than 5%, all else being equal. But, again, we want a wider view: How does that 10% return compare to the returns of other stocks with roughly the same risk characteristics?

Whether using earnings per share with an absolute number or the earnings growth rate with a percentage number, higher is generally better than lower. Earnings per share tells investors how much the company earned in dollars and cents for a specific period, while the growth rate will show how quickly or not earnings are increasing.

On this subject, Tracy attributed changes to three factors: "The key driver of EPS is management success or lack of it, the financing policy of the business or the general strength of the economy." Regarding the economy, he wrote that the strength of the economy was like the rising or falling tide of the ocean; it generally lifts or lowers all businesses, regardless of management competence.

Financing policies, too, can have an effect on earnings per share. Consider a company that issues new shares or cancels some existing shares. If new shares are issued, earnings per share will fall because of dilution. Think, too, of a company that issues new debt. Done well, new debt will add to the bottom line without changing the amount of equity, thus pushing up earnings per share. I say "done well" because if the cost of interest is higher than the returns generated by the new debt, then earnings per share will drop off.

The third factor was management success, and Tracy wrote:


"In fact, management is normally hired because they can ideally lead to superior earnings for the business. Not only does it represent the bottom line for the business, but also its strong influence on the stock price means that it is often the 'bottom line' for the stockholders (the owners). And since management is responsible for the bottom line and the stock price, it can be assumed that EPS is a direct result of management's strategy and implementation."



Turning to drawbacks of the earnings per share ratio, Tracy has already made the point that debt is not included. Logically then:


"This may mean the EPS is somehow being disguised or manipulated without a necessary reference to risk. What is meant by this? Earlier it was said that as a stockholder you want EPS to be increasing over time, but what if an increasing EPS is being driven purely by increased debt? This otherwise good result hides the possible risk being taken on by higher debt levels."



The second drawback raised by the author was on the issue of overreliance. He wrote, "It is often the first headline figure quoted by the financial media and has an immediate impact on the stock price. However, what actually determines the true value of a stock has never been definitively agreed upon and many experts rely on many different statistics and ratios to make their valuations."

To illustrate, he noted that earnings per share is a measure of net income, but many analysts believe that cash flow from operations is a better indicator of performance.

Conclusion

With the earnings per share ratio, Tracy has begun reviewing valuation ratios; i.e., ratios that help us figure how much shares of a stock are worth. And, as value investors know, the purchase price often makes the difference between a successful and unsuccessful investment.

Earnings per share tells us how much income is being generated on each share we own. And generally, the higher, the better. Whether earnings grow or falter, the main driver is usually management, but financing policies and economic conditions may also make a difference.

GuruFocus uses a similar metric called three-year EPS without NRI growth rate; its output is a percentage rather than an absolute number, but it provides the same substance as the earnings per share ratio.

Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.

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This article first appeared on GuruFocus.