The importance and limitations of Earnings Per Share (EPS) in stock analysis

An image featuring various financial elements: a pie chart with a highlighted segment, a coin symbol, a network diagram, and a line graph with multiple intersecting lines, symbolising the analysis of Earnings Per Share (EPS) and its role in stock performance evaluation.

Learn how to use Earnings Per Share (EPS) effectively in stock analysis, its limitations, and why comparing EPS across companies can be misleading.

What is Earnings Per Share (EPS) and why is it so widely used?

Earnings Per Share (EPS) is a popular metric among traders and investors, representing a company’s earnings divided by its number of shares outstanding. EPS provides insight into a company’s profitability on a per-share basis, making it a go-to metric for assessing financial health. The formula for EPS is:

EPS calculation

Despite its popularity, EPS has limitations that can make comparisons across companies problematic. For instance, companies often have vastly different numbers of shares outstanding, which can distort EPS comparisons. Additionally, companies employ various accounting methods to calculate earnings, further complicating comparisons. As a result, EPS should be used with caution, especially when comparing companies in different sectors or with varying share structures.

For more in-depth insights on EPS, see how to use EPS in fundamental analysis >

Why comparing EPS across companies is often unreliable

One of the main issues with EPS comparisons lies in the number of shares outstanding. Since EPS is calculated based on earnings per share, companies with fewer shares can report higher EPS, even if they generate the same total earnings as a company with more shares. This discrepancy can make a smaller company appear as profitable as a larger one, simply due to a smaller share count.

For example:

  • Company A has 1,000,000 shares and $1,000,000 in earnings, yielding an EPS of 1.
  • Company B has 1,000 shares and $1,000 in earnings, also yielding an EPS of 1.

From this example, EPS alone does not provide insight into the relative size or maturity of these companies. The comparison is misleading as it fails to reflect their actual scale, financial health, or market position.

Furthermore, EPS is calculated using various accounting practices. Companies can include or exclude extraordinary items, adjust for diluted shares, or normalise earnings. This variability means that unless the method behind the EPS figure is clearly stated, direct comparisons may be unreliable.

As noted by Kelly and Hora (2008) in The Folly of Making EPS Comparisons Across Companies, comparing raw EPS figures is problematic unless the companies have identical numbers of shares and follow similar accounting practices.

Why EPS growth trends are more valuable than EPS snapshots

When evaluating a company’s EPS, it’s often more insightful to examine the trend in EPS over time rather than a single EPS figure. Observing EPS growth over a three-to-five-year period can indicate the stability and long-term profitability of a company. A steadily rising EPS suggests consistent financial health, while a volatile or declining EPS may signal underlying issues.

Rather than comparing raw EPS across companies, analysts often focus on EPS growth percentage. This approach provides a clearer picture of a company’s ability to increase profitability and, ultimately, shareholder value.

EPS as part of a broader fundamental analysis toolkit

While EPS is valuable, relying solely on EPS to gauge a company’s performance can be misleading. For a more comprehensive view, investors should consider additional metrics, including:

  1. Return on Equity (ROE): Assesses how effectively a company uses shareholder equity to generate profits.
  2. Return on Investment (ROI): Measures the profitability of investments relative to their cost.
  3. Book Value Per Share: Indicates the net asset value per share.
  4. Revenue Per Share: Shows the company’s revenue allocated to each outstanding share.
  5. P/E Ratio: Provides a valuation of the stock compared to its earnings.

Other helpful indicators include dividend yield, free cash flow, and projected earnings growth (PEG ratio). These metrics, combined with EPS, allow for a more nuanced view of a company’s financial health and potential for growth.

The challenges of relying on historical EPS data

One limitation of EPS is that it often relies on historical data, which can quickly become outdated. For example, annual reports may contain figures up to a year old by the time an investor accesses them. This time lag can present challenges, particularly in fast-changing economic conditions where a company’s financial health may shift rapidly. Additionally, accounting methods involve a degree of judgement, and figures in financial reports may be affected by one-off events, economic changes, or unforeseen disruptions.

The reliance on historical data is a common challenge in both fundamental and technical analysis. Fundamental analysts use EPS and similar metrics to forecast performance, while technical analysts rely on backtesting historical price movements. In both cases, the data may not perfectly predict future results, but understanding its limitations allows traders to make more informed decisions.

As Kelly and Hora (2008) emphasise, it’s essential to be cautious when relying on EPS comparisons due to the inconsistencies that may arise from different accounting practices and share structures.

Key takeaways for using EPS in stock analysis

The key takeaway is that no single metric, including EPS, provides a complete picture of a company’s health or growth potential. When used in isolation, EPS may lead to inaccurate conclusions about a company’s profitability or size. Instead, combining EPS with other indicators offers a more balanced approach to understanding a company’s true value.

To get the most from EPS:

  • Focus on EPS trends over time to assess stability and growth potential.
  • Avoid comparing raw EPS figures between companies with different share structures or accounting methods.
  • Supplement EPS with additional metrics, such as ROE, P/E, and book value per share, to form a well-rounded view of the company’s fundamentals.

EPS as a starting point in fundamental analysis

Earnings Per Share is a useful starting point for evaluating a company’s profitability, but it is only one piece of a larger puzzle. Investors should be cautious when comparing EPS across companies, as differences in share structure and accounting practices can lead to misleading conclusions. By focusing on EPS growth trends and using EPS alongside other financial indicators, investors can gain a clearer picture of a company’s financial health and potential for long-term success.

EPS is valuable for its simplicity and ease of calculation, but it’s most effective when combined with a suite of metrics. As a tool for assessing profitability, it can help investors make informed decisions, provided it is used within the broader context of fundamental analysis.

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