Understanding Earnings per Share and its Impact on Stock Price

Understanding Earnings per Share and its Impact on Stock Price
BY STOCK RESEARCH PRO • MAY 9TH, 2009

A company’s Earnings per Share (EPS) represents the portion of the company’s earnings (after deducting taxes and preferred share dividends) that is distributed to each share of the company’s common stock. The EPS measure gives investors a way to compare stocks in an “apples to apples” way.

The Importance of Earnings per Share in Evaluating Stocks
Fundamental stock evaluation revolves primarily around the earnings a company generates for its shareholders. Earnings, of course, represent what the company makes through its operations over any particular period of time. While smaller, newer companies may have negative earnings as they establish themselves, their stock prices will reflect future earnings expectations. Larger companies are judged mainly on the earnings measure. Decreased earnings for these companies are likely to negatively impact their stock prices.

The Earnings Cycle
Earnings are reported every calendar quarter with the process beginning shortly after the end of a fiscal quarter (a three month period).

Calculating Earnings per Share
The formula for earnings per share can be written as:

(Net Income – Preferred Stock Dividends) / Average Outstanding Shares

Because the number of shares outstanding can fluctuate over the reporting term, a more accurate way to perform the calculation is to use a weighted average number of shares. To simplify the calculation, though, the number used is often the ending number of shares for the period.

Investors can then divide the price per share by the earnings per share to arrive at the price to earnings ratio (P/E Ratio) or “multiple”. This ratio gives us an indication of how much investors are willing to pay for each dollar of earnings for any particular company.

Basic v. Diluted Earnings per Share
In calculating the EPS, one of two methods can be used:
Basic Earnings per Share: Indicates how much of the company’s profit is allocated to each share of stock.
Diluted Earnings per Share: Fully reflects the impact the firm’s dilutive securities (e.g. convertible securities) may have on earnings per share.

Types of Earnings per Share
EPS can be further subdivided into various types, including:
Trailing EPS: Calculated based on numbers from the previous year
Current EPS: Includes numbers from the current year and projections
Forward EPS: Calculated based on projected numbers
Please note that most quoted EPS values are based on trailing numbers.

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