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How Earnings Per Share Can Help You Trade Successfully

How Earnings Per Share Can Help You Trade Successfully

Earnings per share (EPS) refer to the fraction of a company’s profits that are typically allocated to each outstanding share. Evaluating this concept is a relatively straightforward process and can act as a game changer. It provides deeper insights into the firm’s profitability levels, as well as its future well-being. Investors can leverage its power to determine if it’s worth investing in the company or not.

Why Earnings Per Share (EPS)?

Positive earnings per share provide an incredible way of assessing the company’s overall wellness. If the company’s earnings have significantly improved, but the total shares haven’t increased, nor the EPS skyrocketed, this might not prove so helpful for the investor. Earnings per share (EPS) provides a clear view of the firm’s profitability and its overall wellness. Besides, it could be a clear indication of the company’s possibility to generate adequate funds and reinvest some of its profits in the near future, providing higher returns for the investor. However, if the company is trending negatively, it means that it’s having some problems and its stock price is more likely to drop.

Defining EPS

If you’re a fan of the stocks market, you have probably come across the term EPS on various occasions. Earnings per share informs you about a company’s profitability in a way that’s useful to investors who’re trying to decide whether to purchase or sell individual stocks.

In other words, EPS refers to a firm’s net earnings for a given period of time,divided by the number of its outstanding stock shares. For instance, if Company A made $100, and there are 100 stock shares available, its earnings per share would be 100/100, which gives us $1.

EPS figures can also be represented over varied periods of time. Trailing EPS, for instance, is calculated using the firm’s net earnings for the past year.

It’s also imperative to know what’s provided in the number of stock shares. EPS figures are often calculated using the number of active shares a company has in the market. Conversely, diluted EPS is determined using free float, as well as convertible instruments like stock options offered to employees that might become common shares in the future. Since it incorporates more shares, diluted EPS will often be lower than basic earnings per share. If you need help understanding this concept, a trading professional like help.

How Is EPS Calculated?

Earnings per share is the measure of a firm’s total net income divided by its outstanding shares. This income statement is typically broken down into three different sections:

  • Direct costs, which often result in net revenue as well as gross margin
  • Indirect costs that commonly result in operating income, also referred to as earnings before interest plus tax (EBIT), as well as operating margin.
  • Net income, which refers to the firm’s earnings after subtracting interest plus tax from EBIT.

A Detailed Breakdown of EPS

Public companies report their EPS in two ways: basic earnings per share, plus diluted earnings per share. Generally, basic earnings per share is obtained by dividing the net income by the free float or active shares available on the market. On the other hand, diluted earnings per share is achieved by dividing the net income by the total shares (including free float and convertible shares).

Most firms, as well as the media, pay more attention to the diluted earnings per share.

EPS Quality

A high-quality EPS represents the company’s true earnings. And this will usually come with minimal non-GAAP earnings adjustments. Plus, it may involve the firm’s earnings recognition strategy. It’s easy for people to overlook these strategies, but they really play an important role when it comes to the evaluation of EPS quality. EPS can also be considered of higher quality when the company is significantly improving its expense management and expanding its margins.

Excessive non-GAAP adjustments, higher expenses, plus unnecessary outstanding shares can be flags for poor-quality EPS reports. The management team can adjust shares outstanding through buybacks as well as new issuance. When it comes to revenue recognition, accounting standards also offer some latitude. However, it’s important for companies to stay ethical in their earnings per share reporting. Not sticking to the standards of revenue recognition can lead to severe management problems, or even lawsuits.

How Does EPS Help an Investor?

When comparing the EPS values of different stocks, it’s imperative to compare firms only within the same sector. Earnings per share demonstrate how well a certain company generates profits for each dollar that shareholders invest.

Investors usually monitor a company’s EPS trajectory before making their investments. Is the firm’s EPS growing or shrinking? A company with an EPS value that’s higher than that of its competitors will probably have increased dividend payments.

Earnings per share is commonly utilized for calculating another key stock analysis concept: price to earnings ratio (P/E ratio). This ratio is a good indicator of the company’s health as expressed via earnings. It’s often calculated by dividing a firm’s stock price by its EPS value.

The Bottom Line

A company’s earnings per share report often attract a lot of attention. Not only does it provide deep insights into the firm’s earnings but it’s also an important measure of performance. That’s why most management, as well as investors, place more significance on it. Of course, the company’s executives can utilize various techniques to manipulate the EPS figure in their favor, but it’s always good for them to understand what EPS represents and use it to boost the quality of their earnings.

An efficient market often leads to greater valuations for businesses with growing, high-quality earnings. While a company’s management can utilize certain strategies to manipulate EPS in their favor, both the market and investors will usually dispute such discrepancies over lengthy periods of time. Gradually depreciating the quality of earnings will eventually result in activist intervention, as well as shareholder lawsuits that seek retribution for overlooking the shareholder’s interests.

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by Brian Perry // Brian Perry is a contributor to Businessing Magazine.

Opinions expressed by contributors are their own.