Earnings per Share Estimates

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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 the company. If you don't take a look at earnings, then you're speculating. 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

Additional Resources

In a nutshell, earnings per share, or EPS, is defined as the net income (or profits) of a company divided by the shares of common stock outstanding. With the earnings per share measure, you are looking at the amount of money left over for shareholders. The value is reported after taxes are subtracted, and we are "normalizing" those profits by stating them on a per share basis.

For example Company A and Company B both earn $1 million each year. But Company A has 1 million shares outstanding, while Company B has 10 million shares outstanding. 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. 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, which can be used to help fund the growth of a company.

Earnings 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 that a company will report out their most recent earnings. They also conduct earnings conference calls to discuss 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 that were subsequently used to produce the average.
High / Low Estimate - this information gives the investor a good feel for the range of earnings estimates. Generally, the closer the high and low estimate, the more confidence in the estimate.

Earnings Surprise

The earnings surprise is a historical look at the earnings estimates versus the actual earnings in a given 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 us is 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. In other words, a positive earnings surprise can make a stock's price increase.

On the other hand, if we 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 investigation 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, this is usually a signal that new information made an analyst revise their 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 of 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, then 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 price of the company's stock.

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 how to use ratios in more detail in our discussion of Understanding Financial Ratios.

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