Investing in stocks is a great way to create a source of income, but an investor should not forget about possible risks. To reduce these risks, traders should know how to calculate some indicators, one of which is EPS.
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In this article, you'll get answers to important questions:
- What is a good EPS indicator for a stock?
- What formula should we use to determine it?
- What is a good EPS number?
- What should investors pay attention to when using the metric?
And you’ll get 7 tips on how to identify the best stocks to buy. The information in this article will help you make the right investment decisions.
What is EPS (Earning Per Share)?
An investor needs to evaluate how much of their risk is justified, as well as on which earnings and expenses they can count on. EPS (Earning Per Share) is one of the essential indicators that help investors assess their risks and potential profits.
So, what is a good earnings per share ratio?
EPS ratio is a financial indicator that results from the ratio of a company's net profit to the number of common shares outstanding during an annual period.
The essence of the EPS ratio, to put it simply, is that each shareholder who owns shares in a company has a stake in its share capital. Equity capital is equal to the number of issued shares of the company. That is, each shareholder has their share of the company's profits. Profit received by the company is distributed in proportion to the share of each shareholder. Accordingly, this ratio determines how great the return on each dollar invested in the company's stock, relative to the profits received (price to earnings). The higher the EPS, the higher the yield of money invested in the shares of the business.
By paying attention to the EPS rating, an investor can estimate the growth rate of profits from owning the stock. Based on the data of this rating, an investor can find solid stocks.
The EPS ratio is one of the main calculation elements used in accounting and financial statements. It is used in the international calculation standards of IFRS and US-GAAP. That is why it is essential to know what a good EPS for a stock is.
What is a Good EPS?
What is a good earnings per share number? Whether it will be good or not depends on a company's recent results, a company’s value, the competitors’ results, and the expectations of analysts who follow the stock. The company can report on high earnings per share, but its stock could fall in price if analysts expected a better performance. Similarly, a decline in EPS can lead to an increase in price if analysts expected even worse results. It is important to always measure EPS relative to a company's stock price, for example, based on price-to-earnings (P/E) or profitability ratios.
You get the idea, what is a good earning per share? Let's reinforce this knowledge with a case study.
Let's calculate the EPS for Apple stock.
To calculate this number, we need to look at Apple's annual report and find information about net income. Apple's net income in the 2021 fiscal year was 94.68 billion.
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The number of shares outstanding — 16.86 billion
Thus, we get the following calculations:
EPS AAPL = 94.68 / 16.86 = 5.61
The value of EPS shows what fluctuations in the company's profitability can be expected in the short term. If EPS is calculated only with the shares outstanding at the moment, it is usually called basic EPS. To calculate the possible impact of diluted capital, it is necessary to calculate diluted EPS.
To evaluate the rationality of investing in a company’s stock, you will need to make ratio calculations, compare companies and estimate the earnings you can get. And now, we give you 7 tips for determining a good earnings per share ratio.
7 Tips to Determine a Good Earnings Per Share Ratio
1. Look at the company's income statement
Before you invest in a company, it's crucial to understand how it manages its expenses. Evaluate metrics such as operating expenses, gross margin, and net margin. After all, if a company can't control its expenses accordingly, its financial results will not be satisfactory. This will affect the company's net income, and therefore the dividends paid to you.
2. Analyze the company's financial situation
All publicly-traded companies must report to their shareholders. You can find out what's going on with the company by looking at EPS reports and its financial statements. Companies publish these on their websites every quarter and then provide a final annual report.
When you open the report, you will probably be amazed at the number of obscure lines you will see. The most important ones to look at are revenue, net income, EBITDA, and equity. A thriving company should be making profits, and its revenue, EBITDA, and equity should be growing. Even without a detailed comparison of ratios, you will get valuable information for your decision.
3. Learn all about dividends
Find out how the company has previously paid dividends to its shareholders, whether there have been any problems with the payments or serious delays. Find out how EPS has changed over time. A positive trend in this indicator increases the likelihood that the company will continue to pay good dividends to its shareholders.
4. Determine liquidity
Liquidity indicates how quickly you can buy or sell a company's stock at market price. It can be high, medium, or low, and the higher the better. If liquidity is low, you don't even need to do an EPS comparison to figure it out, you may get into a situation where you want to sell or buy the stock but can't do it at a reasonable price, which will cost you more.
5. Do a cash flow statement analysis
The cash flow statement allows investors to analyze the quality of the company's earnings and the operating cash flow in particular. You will be able to compare operating cash flow per share to EPS. Many investors note that operating cash flow per share should be higher than EPS.
An important point: If EPS is skyrocketing without a similar increase in operating cash flow, or if that cash flow is negative, that is not a good sign. More often than not, this means that the company is incurring very high operating expenses, possibly due to unrealized accounts receivable.
6. Compare the EPS of your chosen firm to its competitors
The best way to determine how good a company's EPS is is to compare that figure to its competitors from the same industry.
7. Consider Using Multiples
Another thing to consider is the use of multiples.
With multiples, investors often look for undervalued companies whose stock is much cheaper than it should be. This usually happens when the company's performance is good, but no one has noticed it yet. The problem is identifying companies that are definitely undervalued is not easy.
Shares of undervalued companies can be bought with the expectation that their share price will rise in the future. Other investors on the market will also realize how promising the company is and start buying its securities, which will increase their value. The main multiples are P/E, DEBT/EBITDA, ROE, EV/EBITDA, P/BV, P/S.
EPS is not a good measure of performance because it does not consider the opportunity cost of capital and can be manipulated by short-term actions. Even when calculating this figure, an investor runs the risk of buying overvalued shares, which will fall sharply in value. Checking the P/E ratio can protect from this risk. A high P/E ratio could mean that a stock's price is high relative to earnings and possibly overvalued.
P/E shows how much importance the market attaches to a certain company's profits. First, the P/E ratio tells us how much an investor is willing to give for each dollar of a company's earnings data. Secondly, the investor learns their waiting time to recoup their investment through stock returns. Basically, the P/E ratio tells us how confident investors are about the future of the company they are investing in.
Below we will look at this indicator in more detail.
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What Should an Investor Know About P/E ratio?
The P/E ratio shows how many years it will take a company to reach its market value at its current stock price and earnings, as well as good earnings per share for a stock. However, as simple as calculating the P/E ratio is, its role in valuing a stock is complex. Essentially, the P/E ratio helps determine whether a stock's price is low or high. However, the ratio by itself is not meaningful. When looking at the P/E ratio, it is especially important to compare it to companies in the same industry. You should also always check to see how the company has evolved over the past five to ten years.
High P/E Ratio
A high P/E ratio can mean that a company's stock is in high demand and therefore its price is high too. This could be a sign of overvaluation and possibly an indicator of future price declines.
Another possibility, however, is that a high P/E ratio indicates strong sales or earnings growth. Investors may be willing to pay a premium for a fast-growing company.
Low Price/Earnings Ratio
A low P/E ratio means that the stock has a low market valuation compared to the company's earnings. If the company belongs to an industry that is growing very slowly, a low P/E ratio would not be a disadvantage and possibly a reason for buying the stock.
However, if the P/E ratio is low because of gloomy earnings projections, buying the stock is probably not advisable, even though it is currently valued cheaply.
Now you know what a high EPS is and what a good EPS ratio is. EPS, in simple terms, is the ratio of net income to the number of shares, which gives us an understanding of how much can be earned per share. It is used solely for comparative purposes between two or more companies, not as a fixed value.
There are several varieties of EPS, depending on the additional elements in the calculation. For example, diluted, basic, expected EPS. Each of these can be used under different circumstances in a particular strategy.
From all the above, it follows that stock returns can be one of the most important calculations in evaluating a company's economic health. However, it should be remembered that there is no single good EPS value, above which it is advisable to buy a firm's stock and below which it is advisable to sell.
To make an informed decision, you should spend time comparing the EPS of several competing firms. This approach will help you determine the performance of one firm relative to another similar firm or relative to the industry as a whole.
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