Stock Investing 101 – Earnings Per Share

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Earnings Per Share

Earnings per share, or EPS, is the company’s profits attributable to each outstanding share of common stock. It is one of a number of indicators used in financial analysis to assess a company’s performance.

EPS is computed by taking the net income earned (less dividends on preferred stock) by the company during the quarter (or year) and divide that figure by the weighted average number of outstanding shares during that reporting term.

EPS is an important indicator of a company’s performance and is often used for stock valuation purposes. For example, it is used to calculate the price-to-earnings valuation ratio.

As can be seen in the formula shown above, lowering the number of shares outstanding will increase the earnings per share. As EPS impacts stock valuation heavily, companies sometimes buy back their own shares to up the EPS number so as to increase shareholder value.

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Earnings Per Share – EPS Definition

What Is Earnings Per Share – EPS?

Earnings per share (EPS) is calculated as a company’s profit divided by the outstanding shares of its common stock. The resulting number serves as an indicator of a company’s profitability. It is common for a company to report EPS that is adjusted for extraordinary items and potential share dilution. The higher a company’s EPS, the more profitable it is considered.

Key Takeaways

  • Earnings per share (EPS) is a company’s net profit divided by the number of common shares it has outstanding.
  • EPS indicates how much money a company makes for each share of its stock and is a widely used metric for corporate profits.
  • A higher EPS indicates more value because investors will pay more for a company with higher profits.
  • EPS can be arrived at in several forms, such as excluding extraordinary items or discontinued operations, or on a diluted basis.

Earnings Per Share Explained

Formula and Calculation for EPS

The earnings per share value are calculated as the net income (also known as profits or earnings) divided by the available shares. A more refined calculation adjusts the numerator and denominator for shares that could be created through options, convertible debt, or warrants. The numerator of the equation is also more relevant if it is adjusted for continuing operations.

To calculate a company’s EPS, the balance sheet and income statement are used to find the period-end number of common shares, dividends paid on preferred stock (if any), and the net income or earnings. It is more accurate to use a weighted average number of common shares over the reporting term because the number of shares can change over time.

Any stock dividends or splits that occur must be reflected in the calculation of the weighted average number of shares outstanding. Some data sources simplify the calculation by using the number of shares outstanding at the end of a period.

Example

The calculation of EPS for three companies at the end of the 2020 fiscal year follows:

Understanding Earnings per Share

The earnings per share metric are one of the most important variables in determining a share’s price. It is also a major component used to calculate the price-to-earnings (P/E) valuation ratio, where the E in P/E refers to EPS. By dividing a company’s share price by its earnings per share, an investor can see the value of a stock in terms of how much the market is willing to pay for each dollar of earnings.

EPS is one of the many indicators you could use to pick stocks. If you have an interest in stock trading or investing, your next step is to choose a broker that works for your investment style.

Comparing EPS in absolute terms may not have much meaning to investors because ordinary shareholders do not have direct access to the earnings. Instead, investors will compare EPS with the share price of the stock to determine the value of earnings and how investors feel about future growth.

Basic EPS vs. Diluted EPS

The formula used in the table above calculates the basic EPS of each of these select companies. Basic EPS does not factor in the dilutive effect of shares that could be issued by the company. When the capital structure of a company includes items such as stock options, warrants, restricted stock units (RSU), these investments—if exercised—could increase the total number of shares outstanding in the market.

To better illustrate the effects of additional securities on per-share earnings, companies also report the diluted EPS, which assumes that all shares that could be outstanding have been issued.

For example, the total number of shares that could be created and issued from NVIDIA’s convertible instruments for the fiscal year ended in 2020 was 33 million. If this number is added to its total shares outstanding, its diluted weighted average shares outstanding will be 599 million + 33 million = 632 million shares. The company’s diluted EPS is, therefore, $3.05B / 632 million = $4.82.

Sometimes an adjustment to the numerator is required when calculating a fully diluted EPS. For example, sometimes a lender will provide a loan that allows them to convert the debt into shares under certain conditions. The shares that would be created by the convertible debt should be included in the denominator of the diluted EPS calculation, but if that happened, then the company wouldn’t have paid interest on the debt. In this case, the company or analyst will add the interest paid on convertible debt back into the numerator of the EPS calculation so the result isn’t distorted.

EPS Excluding Extraordinary Items

Earnings per share can be distorted, both intentionally and unintentionally by several factors. Analysts use variations fo the basic EPS formula to avoid the most common ways that EPS may be inflated.

Imagine a company that owns two factories that make cell phone screens. The land on which one of the factories sits has become very valuable as new developments have surrounded it over the last few years. The company’s management team decides to sell the factory and build another one on less valuable land. This transaction creates a windfall profit for the firm.

While this land sale has created real profits for the company and its shareholders, it is considered an “extraordinary item” because there is no reason to believe the company can repeat that transaction in the future. Shareholders might be misled if the windfall is included in the numerator of the EPS equation, so it is excluded.

A similar argument could be made if a company had an unusual loss—maybe the factory burned down—which would have temporarily decreased EPS and should be excluded for the same reason. The calculation for EPS excluding extraordinary items is:

EPS From Continuing Operations

A company started the year with 500 stores and had an EPS of $5.00. However, assume that this company closed 100 stores over that period and ended the year with 400 stores. An analyst will want to know what the EPS was for just the 400 stores the company plans to continue with into the next period.

In this example, that could increase the EPS because the 100 closed stores were perhaps operating at a loss. By evaluating EPS from continuing operations, an analyst is better able to compare prior performance to current performance.

The calculation for EPS from continuing operations is:

EPS and Capital

An important aspect of EPS that is often ignored is the capital that is required to generate the earnings (net income) in the calculation. Two companies could generate the same EPS, but one could do so with fewer net assets; that company would be more efficient at using its capital to generate income and, all other things being equal, would be a “better” company in terms of efficiency. A metric that can be used to identify companies that are more efficient is the return on equity (ROE).

EPS and Dividends

While EPS is widely used as a way to track a company’s performance, shareholders do not have direct access to those profits. A portion of the earnings may be distributed as a dividend, but all or a portion of the EPS will be retained by the company. Shareholders, through their representatives on the board of directors, would have to change the portion of EPS that is distributed through dividends in order to access more of those profits.

Because shareholders can’t access the EPS attributed to their shares, the connection between EPS and a share’s price can be difficult to define. This is particularly true for companies that pay no dividend. For example, it is common for technology companies to disclose in their initial public offering documents that the company does not pay a dividend and has no plans to do so in the future. On the surface, it is difficult to explain why these shares would have any value to shareholders.

The actual notional value of EPS also seems to have a relatively indirect relationship with the share price. For example, the EPS for two stocks could be identical, but the share prices may be wildly different. For example, in October 2020, Southwestern Energy Company (SWN) earned $1.06 per share in diluted earnings from continuing operations, with a share price of $5.56. However, Mellanox Technologies (MLNX) had an EPS of $1.02 from continuing operations with a share price of $70.58.

On the surface, it seems like SWN is the better deal because an investor is only paying $5.25 per dollar of earnings ($5.56 share price / $1.06 EPS = $5.25). Investors in MLNX are paying $69.20 per dollar of earnings ($70.58 share price / $1.02 EPS = $69.20). This ratio is also known as the earnings multiple or Price/Earnings (PE) ratio.

Although the comparison between MLNX and SWN is extreme, investors will generally find a comparison of EPS and share prices between industry groups to be difficult to compare. Stocks that are expected to grow (e.g., technology, retail, industrial) will have a larger price-to-EPS (PE) ratio than those that are not expected to grow (e.g., utilities, consumer staples).

EPS and Price-To-Earnings

Making a comparison of the P/E ratio within an industry group can be helpful, though in unexpected ways. Although it seems like a stock that costs more relative to its EPS when compared to peers might be “overvalued,” the opposite tends to be the rule. Investors are willing to pay more for a stock, regardless of its historical EPS, if it is expected to grow or outperform its peers. In a bull market, it is normal for the stocks with the highest PE ratios in a stock index to outperform the average of the other stocks in the index. (For related reading, see “Understanding P/E Ratio vs. EPS vs. Earnings Yield“)

Investing For Beginners: How To Read A Stock Chart

Modified date: July 31, 2020

If you do decide to invest in individual stocks, we don’t suggest you allocate more than 10 percent of your portfolio to individual stock picking. This article focuses on how to evaluate individual companies.

If you’re an experienced investor and want to learn a key tool for picking individual stocks, read on.

If you’re new to investing (or even if you’re not) you’d probably agree that reading a stock chart isn’t all that exciting. But it’s a core skill you’ll need if you want to find viable investments for your portfolio.

Well, welcome to how to read a stock chart for beginners!

In the article, I’ll break down the essentials stock chart and explain the key things you need to focus on.

Pair this with some knowledge of value investing and you’ll be well on your way to picking stocks.

What is a stock chart?

My favorite website to look at basic stock information is Google Finance. I used to use Yahoo! Finance, but I think Google has a slicker interface.

Now let’s take a look at a typical stock chart. We’ll use Apple for this article.

If you don’t already know, the series of letters after the name of the company is the ticker symbol. It identifies the company on the stock exchange.

In this case, we’ll search AAPL, which is Apple’s ticker symbol. This is what we get:

Next, click the button to expand the chart to full screen and it’ll look like this:

I’ve also taken the liberty of filtering only to the last 10 years, which you can easily do by clicking the corresponding button (which I’ve highlighted for you).

So here we’re looking at the last 10 years of Apple’s stock. I bet you wish you would have gotten in in late 2008!

Now let’s dive into the different pieces and parts of the stock chart so you can begin to read one like a pro.

How to read a stock chart

1. Identify the trend line

This is that blue line you see every time you hear about a stock—it’s either going up or down right? While the trend line seems like common sense, there are a few things I want to call out so you can understand it in a little more detail.

First, know that stocks will take huge dives and also make huge climbs. If you’ve followed the advice I gave in the value investing piece, you’ll know that you have to keep your emotions in check to be a successful investor.

Don’t react to large drops or huge gains in a positive or negative way. You should be using this piece of the stock chart merely to see what’s going on.

In fact, the trend line should lead you to dig further. For instance Apple as a company really took off from 2009 to 2020.

But what happened from 2020 to 2020? The stock began to sink—at one time, shares were down more than 4o percent!

This is where your trend line comes in handy. News comes and goes, but when news coincides with a dramatic shift in the trend line, it’s something to pay attention to.

If you saw something like this happen, I’d urge you to find out what’s going on with the company. Most strong companies can rebound from hits like this, but not all can.

For those that don’t know, right around this time Apple experienced a few major shifts:

First, it’s longtime CEO, Steve Jobs, resigned (2020). Also, around 2020, Apple noted that their profit margins were significantly decreasing, despite a growing smartphone market. Finally, they were trying to expand the smartphone into developing countries, where they were just too expensive to compete.

These factors, combined with plenty of other variables, contributed to the stock price falling.

But new CEO Tim Cook made some strategic moves with the company to turn it around, and the rest of the trend line shows that.

The lesson here is to use your trend line as a first-glance, high-level indicator of something to look into.

2. Look for lines of support and resistance

The next thing you’ll want to look at are the lines of resistance and support.

These are levels at which the stock stays within, over a given period of time. A level of support is a price that a stock is unlikely to drop below, while a level of resistance is one that it’s unlikely to go above.

That is until some major change occurs, such as a reduced profit margin.

Think of these lines like bumpers at a bowling alley. When you’re bowling, the ball bounces back and forth between these inflated barriers.

A stock’s price does the same thing within these lines of support and resistance.

The goal here is to know when to buy and when to sell. Let’s take a look at Apple’s stock chart again to see an example:

These are subjective and interpreted differently by everyone, but the process is important. First know that everyone will draw lines of resistance and support differently, depending on their investment horizon (how long they plan to hold the stock).

So if you plan on holding it for a long time, you may not draw as many lines of support and resistance, because you don’t care as much about the ups and downs. But if you’re a short-term investor, you may draw more to analyze trends during a shorter period.

Let me break down the image above with each of the trend lines:

  • Line A is the very first line of support shown. Based on trends prior to this, I’d feel comfortable that the stock price won’t go below this point. I’d probably consider buying at this price or higher.
  • Line B is my first line of resistance. I see that the stock has peaked at that point for now and I wouldn’t expect it to go higher. I’d probably consider selling at this price or slightly lower.
  • As you can see with Line C, the stock has bottomed out again, thus creating a new line of support.
  • Line D shows the stock price has increased significantly and I’m comfortable establishing this as a new line of resistance.
  • You can see the trend continue with Lines E, F, G, and H, bringing new lines of support and resistance as time goes on.

If it seems complex, don’t fret. It is. And a lot of it is guesswork.

If I were to buy stock in Apple today, I’d make note of my most recent line of resistance (Line G) pricing out at just over $130 a share and my most recent line of support (Line H), which was pricing at around $90 a share.

Knowing this, I can safely assume that the stock price won’t drop below $90 and it shouldn’t go above $130, barring any major news or company changes.

At $113 per share currently, I feel that this is a good price point and would probably make a purchase. I might even wait to see if it drops below $110 to feel even better.

Knowing the lines of resistance can help you decide when to buy or sell a stock. Remember, though, that it’s subjective and it won’t give you a clear-cut road map on exactly what to do. You’ll have to use some of your own analysis and judgement.

3. Know when dividends and stock splits occur

At the bottom of the chart, you’ll see if and when the company issued a dividend, as well as if there was ever a stock split:

A dividend is when the company (the board of directors) decides to give a portion of its earnings back to its shareholders. If you own the stock, you get a small chunk of the profit.

Some companies issue dividends, some don’t. Just because a company does or doesn’t issue a dividend doesn’t mean it’s not worth investing in. There are plenty of other factors to consider.

Some companies just prefer to focus on growth, so they’ll reinvest their earnings as opposed to giving it back to the shareholders. Other companies (like Apple) can pay dividends without sacrificing growth.

As you can see by the image, Apple started issuing quarterly dividends to its shareholders midway through 2020.

You can also see that there was a stock split in 2020. A stock split is a strategic move done by the company’s board of directors to issue more shares of stock to the public.

In this case, Apple did a seven to one stock split (noted as 7:1), which means that for every share of AAPL you owned prior to the split, you’d now have seven. So if I owned 100 shares of APPL prior to the split, I’d now have 700.

The value of the company doesn’t change, but the share price might. Companies will often do this if the price isn’t in line with competitors or to attract smaller investors (if the share price decreases).

You can see the uptick in the trend line after the split occurred, too. Many times when a stock split happens, more people invest (since the share price is often lower) which increases demand and, in many cases, the overall share price.

4. Understand historic trading volumes

At the very bottom of the chart you can see many small, vertical lines. This is a trend of the volumes at which the stock is traded.

Volumes are good to know, but shouldn’t be your only determining factor when buying a stock. Usually trading volumes increase when there is major news (good or bad) about the company.

When volumes are increasing, it can also shift the price of the stock quickly. Let’s look at an example:

In Line A, you can see there was a high volume of trading activity that corresponded with a drop in the stock price. There may have been news that day that caused people to panic (aside from the entire economy crashing that year).

In Line B, you can see a slight uptick in trading volume that corresponds with an upward trend in the stock price.

Don’t always assume there will be a correlation between stock price and trading volume, but it’s good to know what the volumes have been in the past and what they are currently before making a decision.

With high volumes comes greater ease when buying or selling. If a lot of people are trading the stock that day, you should be able to buy or sell it quickly.

Summary

That’s the basics of how to read a stock chart. Once you’ve mastered these techniques, you should be able to analyze a stock’s historic activity at a high level.

Remember that past performance doesn’t correlate to future indications on price. Meaning that just because Apple hit $130 per share recently doesn’t mean it will again. There’s also nothing to say it won’t double in price. You just can’t know.

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