It is very important for an investor to assess how justified his risks will be, what profit he should expect.
To solve such problems in the world practice of fundamental analysis, a number of simple mathematical indicators are used, with the help of which any investor can assess both his risks and potential profit. These include the earnings per share ratio – ЕРS (Earning Per Share – earnings per share).
Further in the article, it will be discussed in detail not only what the EPS indicator means and how it is calculated, but also about the practice of its use, where it can be found, about all the advantages and limitations of using such indicators.
What is EPS in simple words
In its classic definition, the EPS ratio is a financial indicator that is the result of the ratio of a company’s net profit to the number of ordinary shares outstanding during a year.
The essence the EPS coefficient in simple words is that each shareholder who owns shares in the company has his share in its authorized capital. The authorized capital is equal to the number of issued shares of this business. Those. each shareholder has his own share of the company’s profits. The profit earned by the company is distributed in proportion to the share of each shareholder. Accordingly, this ratio determines how great is the return of each ruble or dollar invested in the company’s shares, in relation to the profit received. The higher the EPS, the higher the return on investment from investing in the stocks of this business.
EPS in simple terms is an indicator of how profitable it is to buy a company’s stock.
The ЕРS ratio is one of the main calculation elements used in the preparation of accounting and financial statements. Used in international calculation standards IFRS and US-GAAP.
How to calculate EPS for a stock
The general calculation scheme is as follows:
EPS = (P- Diν) / S
- Р – net profit after taxes.
- Diν is the amount of dividends on preferred shares.
- S is the number of common shares in circulation.
In this calculation scheme, the amount of dividends received by shareholders is excluded from profit. This is done in order to exclude double counting of dividend income when calculating earnings per share.
However, this method of calculation has one significant drawback, which is that the concept of “profit” is very conditional. Indeed, it is not uncommon for a company to work. customer orders are fulfilled, employees and management receive salaries and bonuses, bonuses, some funds are invested in projects, but her profits are either small or completely equal to zero.
Those. any really profitable company can be made unprofitable “on paper” by simple manipulations with financial statements.
To compensate for this drawback, a more refined scheme for calculating the EPS indicator is used. This is the so-called “money ratio”.
Cash EPS = (OCF-Div) S
- OCF (Operating Cash Flow) – operating cash flow;
- Div (Dividends on Preferred Stock) – dividends on preferred shares;
- S is the average annual number of issued and outstanding all shares.
This method of calculation operates instead of the concept of “net profit” by a more objective and difficult to conceal characteristic of the company’s work – the current operating cash flow. It cannot be hidden, since it is enough to compare the incoming cash flow and the company’s expenses in the lines of the balance sheet.
Example: Company XXX for the reporting year made a profit in the amount of $ 10,000,000 or at the exchange rate of RUB 640,000,000.
The number of the company’s shares in circulation as of the date of the close of the register of shareholders is 10,000,000.
At the annual general meeting of shareholders, it was decided to allocate RUB 300,000,000 for dividends, including on preferred shares. The rest of the profit is used for business development. Accordingly, the formula for calculating the EPS ratio in this case will be as follows:
EPS = 640,000,000 rubles. – 300,000,000 rubles 10,000,000 pcs. shares = 340,000,000 10 mln. shares = 34 rubles pcs.
The calculation example shows earnings per share of 34 rubles. However, there is another question – how much is the share itself. If it costs 1 ruble, then the investor has 34 rubles of profit for almost every ruble invested. And if the share is worth 1,000 rubles, then it turns out that for each ruble invested, he will receive only 3.4. penny.
As you can see from how the EPS is calculated, this indicator alone is not enough for making an investment decision. Or, in any case, such an indicator can only be used in comparison with other similar companies – competitors, by industry or type of business.
EPS is a fundamental analysis indicator that shows the overall efficiency of an investor’s investment in stocks of a particular business.
How to use EPS when buying stocks
The ЕРS indicator can be used to solve several problems in fundamental analysis. Most often it gives good results when solving the problem of choosing which stocks to buy.
Consider the situation as an example. There is a decision to invest an investor’s money in shares of Russian oil companies – which is the best one to choose?
There are five options:
- PJSC Gazprom Neft (SIBN);
- PJSC LUKOIL (LKOH);
- NK Rosneft (ROSN),
- 4. OJSC Gazprom (GAZP);
- OJSC Novatek (NOTK).
All company data are summarized in a general table:
As can be seen from the table, Lukoil has the highest ЕРS indicator – $ 5.71 per share.
Choosing such a stock without considering other indicators in the investor’s portfolio is the right decision. According to this indicator, Lukoil looks the best in comparison with other companies.
The company tries to distribute most of the profits among investors, pays them generous dividends. This is the most important factor in making a rational choice for an investor.
Although in fact, if we use all the other indicators, then in the first place will be the company OJSC Gazprom Neft, which has a higher ЕРS than other competing companies.
Let’s give another illustrative example of choosing stocks for investing in the American stock market.
There are two companies – Lockheed Martin Corporation and The Boeing Company.
Both companies are similar in terms of business structure and sales markets, and even in terms of capitalization, they are typical analogues.
Which of these companies should you invest in if you take into account EPS? Lockheed Martin has 20.9, Boeing 6.52.
If we proceed from the calculation of the coefficient, then the preference should be given to Lockheed Martin, whose EPS is more than three times higher.
What is the diluted profit ratio
Joint-stock companies often use share capital schemes, when in its structure, in addition to ordinary shares, there are classes of shares that can be converted into preferred ones or vice versa.
Since the indicator of the number of preferred or convertible shares is directly included in the calculation format, changing their number up or down can also change the final amount of net profit for which the final EPS is calculated.
EPS Advantages and Disadvantages
The main advantages of using the EPS indicator as an indicator of earnings per share for investment analysis purposes are as follows:
- Availability of application even by non-professional investors;
- Visibility – i.e. you can immediately get an objective primary indicator of the company’s performance, its ability to bring profit to the investor;
- To calculate this coefficient, you can use many open sources of information, which makes it possible to assess the correctness of the data;
- Relatively small influence of the used input data on the accuracy of the readings of this indicator. The number of shares for a fairly short period of time (in the period up to 1 – 1.5 years) remains practically unchanged, and the manipulation of profit figures cannot greatly affect the overall dynamics of this indicator when comparing it over several years.
The disadvantages of this financial indicator, first of all, include:
- EPS is a financial measure that has absolute value only. This means that it can be used to assess the performance of a company only over time, comparing data over several years or in comparison with similar types of businesses. For companies that have a long history of working in the market, it will not be difficult to find all the data. But for businesses, whose shares have become relatively recently quoted on the stock market, such an indicator should be used with great care.
- Since errors or direct manipulation of financial statements cannot be completely ruled out, the profit indicator included in the formula for calculating ЕРS can give a significant error in the overall assessment of the company’s profitability in a short period of time. This should always be considered by the investor.
Common mistakes when using EPS
Despite the fact that the indicator of profitability of a joint-stock company, the ratio EPS, is simple and is based on the use of open information, it is worth paying attention to a number of possible errors in its application.
The first mistake – confusion often arises with what exactly characterizes the EPS. Most often, its indicators are mistaken for the ratio of the investor’s profit to the invested ruble.
However, the number of shares, which is the denominator in the calculation formula, is in units, not in price. Accordingly, at one share price – the coefficient may have one value, and at a different price – a completely different calculation of earnings per share
The second error – the earnings per share ratio cannot be used without taking into account its temporal dynamics. Since this is an absolute numerical indicator, it needs to be looked at over a period of several years in order to truly assess how the company has received and distributed profits to its investors.
As a conclusion, it should be noted that the EPS indicator in fundamental analysis matters, despite all its shortcomings.
It provides an answer to the most important question – what size of earnings per share the company is willing to give as a reward to investors.
The higher the EPS, the more fairly the management treats the investors who have invested their money in the business.