What a 4 Year Old Teaches Us About Earnings Per Share

Cash Register Close UP

So, I overheard a Dad say something interesting to his 4-year old son (at least he looked to be about 4). His son asked him a question and he said: “I just answered that question, so I’m not going to answer it again”.

That approach would have saved me a lot of time when my kids were small…..

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But it brings up an important point for investors, because you’re bombarded with data and it’s hard to know what questions to ask. When it comes to stock performance, one critically important measure of performance is earnings per share (EPS), and EPS has more than one definition. Make sure you’re clear about which EPS number you’re told- the numbers are very different.

Considering how a stock is performing

Let’s assume that you own IBM common stock, and that you check Google Finance to see how the stock is performing. I’ve accessed the site as of July 19, 2016. The top center of the page lists some key stats and ratios. Earnings per share (EPS) is listed as $13.28 per share, and if you place your cursor over that statistic, you see a definition: “The net income over the last four quarters divided by shares outstanding”.

EPS tells you how much in earnings a company is generating per common stock share outstanding, and it’s a hugely important number. In past blogs, I’ve compared the ability to generate earnings to a play-doh toy. A company raises capital, and that’s the play-doh going into the toy. After that, the company makes a product or provides a service- which is like turning the crank on the toy.

What comes out the other end? Earnings. Successful companies raise capital, invest that capital into assets and generate profits- year after year. When you buy a stock, it’s as if you’re buying a machine that generates profit, and the more profit a firm can generate per dollar of capital invested (or assets purchased), the more valuable the company is to investors. That’s a big driver of stock price increases.

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The apples-to-apples comparison

So, we agree that EPS is important, and that an investor should consider the EPS of any stock owned. That stock may be in your personal portfolio, or you may own shares of your employer’s stock. If, instead, you own a mutual fund, take a look at the fund’s largest stock holdings- how is the EPS trending for those stocks?

It’s also important to know what “version” of EPS you’re looking at, because you need to be able to compare the same EPS computations between years. That’s an effective way to identify a trend in a company’s EPS. Here are some variations on EPS:

  • Basic EPS: (Net income – preferred dividends) / (weighted average number on common shares outstanding). The plain old vanilla version of EPS. Note that preferred dividends are subtracted, because this ratio only considers earnings available to common shareholders.
  • Fully diluted EPS: Basic EPS is adjusted for any securities that can be converted into common stock, and that may include stock options, convertible bonds, convertible preferred stock, rights and warrants. This ratio assumes that any shares that can be converted into common stock are converted. Since there are more shares outstanding for the same dollar amount of earnings, diluted EPS is lower than basic EPS.
  • Projected vs. historical earnings: Is the earnings amount in the EPS calculation for the last fiscal year, or is it based on a future earnings estimate?

If you understand the EPS calculation being presented, you can make comparisons with past years and find an upward or downward trend in the company’s earnings.

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As always, these posts are for informational purposes only. Consult a financial or tax advisor as needed.

Ken Boyd

Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies

Co-Founder: accountinged.com

(email) ken@stltest.net

(website and blog) http://www.accountingaccidentally.com/

(you tube channel) kenboydstl

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David Tarwin, Cash register close up

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