Perhaps the most important metric to understand before investing money in the stock market is earnings per share. In fact, because of the importance of this ratio to shareholders, a great deal of time is spent by market analysts developing and evaluating earnings per share estimates.
Earnings per Share Concepts
A company's earnings per share, or EPS, is found by taking net income (or profits) divided by the shares of common stock outstanding. This measure allows the analyst to understand the amount of money left over for each share of stock issued to the public. The value is reported on an after-tax basis.
For example, both Company A and Company B earn $1 million each year. But Company A has 1 million shares outstanding, while Company B has issued 10 million shares. Company A's EPS is $1.00, while Company B's earnings are $0.10 per share.
When a company is profitable, and has money to give back to shareholders in the form of earnings, the company has two basic options. They can distribute some of the earnings in the form of a stock dividend. Money that is not paid out as dividends is placed into retained earnings. These profits are now a source of capital, which can be used to help fund the company's growth.
Reports and Estimates
Companies understand how important earnings are to the market as well as shareholders. They often publish what are called earnings calendars, which is the date a company will report out their most recent financial performance. They also conduct conference calls to discuss changes in their company's outlook that might affect future earnings.
When researching a stock for investment purposes, there are several different types of reports or estimates:
Large companies often have several market analysts that follow their operations closely enough to be able to develop earnings estimates. These estimates are usually quoted in terms of an average of all the analysts' predictions. Analysts usually publish estimates for the most recent quarter, the next quarter, the current fiscal year, and the next fiscal year.
Information that typically accompanies these estimates includes:
The earnings surprise is a historical look at estimates versus the actual earnings in a given accounting period. This information is usually stated on a quarterly basis, and includes four or five quarter's worth of data.
The earnings surprise tells the investor how close the analysts came to predicting the actual earnings. When a company earns more than predicted, that's usually good news for a stock in terms of its price. A positive earnings surprise can make a stock's price increase.
On the other hand, a lot of negative surprises can mean a company has problems the analysts don't completely understand. That's usually not a good sign, and requires further investigation before buying stock in a company.
The consensus EPS trend allows the investor to understand the recent direction of earnings estimates. The trend shows the investor how the estimates have been changing as new information is published by the company. Trends are usually shown for 90 days, 60 days, 30 days, and 7 days.
If the earnings estimates are declining over time, this is usually a signal that new information made an analyst revise their forecast downward. Generally, an investor wants to see values that remain steady or move in a positive direction.
Earnings Growth Rate
Published earnings growth rates normally include the last five years, the current fiscal year, the next fiscal year, and the expected growth rate for the next five years. The information for each company is usually compared to an overall market index, such as the S&P 500, and the industry in which the company competes.
Growth Rate Example
For example, if Sam is trying to predict what her shares of Coca Cola might be worth in five years, she'd want to understand what the earnings for Coca Cola might be in five years. She can develop this estimate herself using the five year earnings information along with the stock's price to earnings ratio, or P/E ratio.
By multiplying the future earnings per share by the current P/E ratio, she can develop an estimate of the stock's price in year 5.
That's a relatively simple approach to making future stock price estimates based on earnings. A broader discussion of ratios and their usefulness appears in our article: Understanding Financial Ratios.
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