Fundamental Analysis: Understanding Earnings Per Share

To most people, gross revenue is the barometer for success. But, if you're a stock market investor, you should drill down even further during your fundamental analysis when you're looking at buying (or selling) a stock. When you do, it will lead you to the most important metric of all, earnings per share (EPS).

How Is Earnings Per Share Calculated?

A company's EPS is calculated using the following formula:

For example, say you have two companies, Company A and B. Each had gross revenues of $500 million last year. If A had a net income of $100 million, and B had a net income of $50 million, your gut reaction might be to say that A is a better buy than B. Here is where EPS comes into play.

Let's say that A has 50 million shares outstanding, but B only has 10 million. Using the EPS formula, and assuming neither company pays dividends, it would look like this:

Company A

($100,000,000 - $0) ÷ 50 million shares = $2.00 per share

Company B

($50,000,000 - $0) ÷ 10 million shares = $5.00 per share

With A, the earnings are $2 per share, and with B, the are earnings are $5 per share. Based on the EPS, Company B is by far the better choice. This is why it makes sense to look at EPS as a tool to compare firms because it more fully shows the theoretical value per share that a company is worth. This is not something you can tell with revenue numbers alone.

The EPS calculation is just a starting point in an overall fundamental analysis strategy. However, it is one of the most important parts because other fundamental metrics are derived from it. There are even three different types of EPS numbers:

• Trailing EPS: Uses the previous year's numbers and is viewed as the true EPS.
• Current EPS: Uses the current year's numbers but are projections.
• Forward EPS: Estimated EPS numbers for the following years based upon the current trend.

As you become more adept with fundamental analysis, you can start tracking the EPS of a company to see if they are increasing or decreasing. You'll even be able to observe the rate at which they are.

Other Earnings Related Measures

• Price to Earnings Ratio (P/E): The ratio of a company's share price compared to its EPS.
• Projected Earnings Growth (PEG): A stock's P/E ratio divided by the growth rate of its earnings.
• Price to Sales (P/S): A company's market capitalization divided by its total sales for the year.
• Price to Book (P/B): A company's stock price divided by its book value per share.
• Dividend Payout Ratio: The amount of money paid out to shareholders as dividends relative to the company's net income.
• Book Value: The company's value after subtracting all liabilities from all assets as reported in its financial statements.
• Return on Equity (ROE): The profitability of a business relative to its equity.