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 If you're new to investing in stocks, then earnings per share is perhaps the single most important topic you should understand before investing money in the market. Earnings per share are where the financial "rubber" meets the road. In fact, because of the importance of earnings to shareholders, a great deal of time is spent developing and evaluating earnings per share estimates.
Whenever you research a stock you should carefully examine the earnings information for a company. If you don't take a look at earnings, then you're speculating - enough said. The reason earnings are so important to stockholders is because they tell you about the relative profitability of a company.
Defining Earnings per Share Concepts
In a nutshell, earnings per share (EPS) is defined as the net income (or profits) of a company divided by the shares of common stock outstanding. So with earnings per share you are looking at the amount of money left over for shareholders - after taxes - and "normalizing" those profits by stating them on a per share basis.
For example Company A and Company B might each have earnings of $1 million. But Company A has 1 million shares outstanding, while Company B has 10 million shares outstanding. So 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. And whatever is not paid out in the form of dividends is placed into the retained earnings - which then become a source of money, or capital that can be used to help fund the growth of a company.
Earnings Reports and Estimates
Companies understand how important earnings are to the market and shareholders and they often publish what are called earnings calendars - which is the date that a company will report out their most recent earnings. They might also conduct what is called an earnings conference call to discuss possible changes in their financial outlook that might affect future earnings.
When researching a stock for investment purposes, there are several different types of earnings reports or estimates that you will encounter:
- Analyst Earnings Estimates
- Earnings Surprise
- Consensus EPS Trend
- Earnings Growth Rates
Analyst Earnings 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 predict estimates for the most recent quarter, the next quarter, the current fiscal year and the next fiscal year.
Information that also accompanies these earnings estimates includes:
- Number of Analysts - this gives you an idea of how many analysts provided estimates were used to produce the average.
- High / Low Estimate - this information gives you a good feel for the range of earnings estimates. Generally, the closer the high and low estimate, the more confident you can be in the estimate itself.
Earnings Surprise
The earnings surprise is a historical look at the earnings estimates versus the actual earnings in a give period. This information is usually stated on a quarterly basis and includes four or five quarter's worth of information.
What the earnings surprise tells you is how close the analysts came to predicting the actual earnings. When a company earns more than predicted, that's usually good new for a stock in terms of its price. In other words, a positive earnings surprise can make a stock's price jump up a bit.
On the other hand, if you see a lot of negative surprises, this can often mean a company has problems that the analysts don't completely understand. That's usually not a good sign and requires further investigationon your part before buying stock in the company.
Consensus EPS Trend
The consensus EPS trend can give you a good feel for where the earnings estimates have been heading lately. In other words, the EPS trend shows you how much the estimates are changing based on new information. EPS trends are usually shown for 90 days, 60 days, 30 days and 7 days. You won't see a trend longer than 90 days since that is approximately one quarter long.
If the earnings estimates are declining over time that usually signals new information has come in that has made an analyst revise a forecast downward. Generally, you want to see an estimate remain steady in its trend or move in a positive direction. In other words, you'd like to see the current EPS higher than the estimate was 90 days ago.
Earnings Growth Rate
The final type of earnings information we're going to discuss is the earnings growth rate. Earnings growth rates are normally stated in terms the last five years, the current fiscal year, the next fiscal year, and the expected earnings growth rate for the next five years.
The information for a company you're researching is usually compared to an overall market index - such as the S&P 500 - and the industry in which the company competes. That means the company's earnings growth rate appears alongside the market index for direct comparison.
If you're thinking about investing in a company and holding onto that stock for several years, you'll want to pay close attention to the earnings growth rate over the next five years. That's because the company's earnings will usually have a direct relationship to the company's stocks price.
Earnings Growth Rate Example
For example, if you're trying to predict what your shares of Coca Cola might be worth in five years, you'd want to understand what the earnings for Coca Cola might be in five years. You can develop this estimate yourself 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, you 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. We'll talk about that how to use ratios in a bit more detail in our discussion of Understanding Financial Ratios.
About the Author - Earnings per Share Estimates
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