How EPS affects stock prices

When earnings season comes around, publicly traded companies will announce their financial reports to the public.

With so many financial data and performance figures in the report, one ratio tends to get the most attention from investors.

That's the earnings per share.

Earnings per share, or EPS, measures a company's profitability per outstanding share of common stock. In other words, it shows how much a company earns for each share.

You will often see two EPS measures in a company's earnings report — basic and diluted.

Basic EPS is computed by dividing a company's net income by the number of outstanding common shares. For example, if Company A has a net income of $10 million and has 5 million shares of common stock outstanding, it has an EPS of $2 per share.  

If the company has also issued preferred shares, then the amount paid in dividends on preferred stocks is subtracted from the net income first. 

Back to the previous example, if Company A pays out $1 million in preferred dividends, the formula to calculate basic EPS would be $10 million minus $1 million, then divided by 5 million, which results in an EPS of $1.8.  

Unlike basic EPS, diluted EPS uses a more detailed calculation for outstanding shares.

To calculate diluted EPS, divide net income by the common shares outstanding plus the potential number of shares that would be outstanding. This can include preferred shares, convertible bonds, and stock options. For this reason, diluted EPS is typically lower than the basic EPS figure.

For investors, it is important to track a company's EPS performance over time. EPS could be significant in determining a company's stock price in the long run. A steadily rising EPS may drive up a company's share price, while a declining EPS may signal a decrease in the company's share price.

However, strong earnings may not necessarily result in a higher stock price in the short run, and vice versa.

Analysts' expectations also matter.

Analysts' expectations refer to the estimates of the number that individual analysts, investment banks, or financial services companies think earnings will hit. When a company reports EPS that beats the estimate, it's called beaten estimate, and the stock price usually moves higher. If a company reports EPS below analysts' estimates, it is said to have missed estimates, and the stock price may move lower.

Investors may want to invest in companies with steadily rising EPS. But keep in mind, an increasing EPS doesn't necessarily mean the company is doing better.

Companies can increase their EPS in two ways: increase net income and reduce shares outstanding.

If the outstanding shares remain relatively constant, a company could boost the EPS by increasing the net income. This could be a good sign, indicating that the company is making more money.

However, investors should be careful if the company's net income was increased due to a one-time event, as it is non-recurring.

A company could also generate higher EPS by reducing the number of shares outstanding. For example, companies increasingly used their cash to buy back their stock in recent years. In this way, the company reduces the number of shares outstanding and inflates the EPS given the same level of earnings.

In conclusion, EPS is a commonly used measure of a company's profitability.

It is also most closely watched by investors because EPS has a significant impact on a company's stock price.

This marks the end of the video. See you next time!