19.1 Earnings per Share: Overview
Just how important are earnings per share? Before that question can be answered, it is important to understand what this metric is. Earnings are simply a company’s net income or net profit. As every company has a different number of shares owned by its shareholders, comparing only their earnings figures is like comparing apples to oranges. It does not indicate how much income each company earned for each of its common shareholders. So, earnings per share (EPS) becomes a per share way of describing net income, making EPS a good metric for shareholders and potential investors.
Earnings season is the stock market’s equivalent to a school report card. It happens four times per year in many countries where publicly traded companies report their financial results. Although it is important to remember that investors look at all financial information, EPS is the most important number released during an earnings season and it attracts the most attention and media coverage. Before earnings reports come out, stock market analysts issue earnings estimates in terms of what they think earnings will be. Research firms subsequently compile these forecasts into a consensus earnings estimate. When a company is able to beat this estimate, it is called an earnings surprise, and the stock market price usually moves higher. Conversely, if a company releases earnings below these estimates, it is said to disappoint, and the market price for the stock typically moves lower. It is difficult to guess how a stock will move during an earnings season as it is based on expectations, which supports the efficient market hypothesis. Shareholders and potential investors care about EPS because it ultimately drives stock prices.
Sometimes a company with a sky-rocketing stock price might not be making the earnings to support the rise, but the rising price means that investors are hoping – the expectation factor – that the company will be profitable in the future. But, there are no guarantees that the company will fulfill investors’ current expectations.
When a company is making net income and has a positive EPS, it has two options. First, it can retain its net income to improve its products and develop new ones. Second, it can either pay a dividend as a return on investment, or offer a share buyback at a higher price. In the first instance, management reinvests profits in the hope of making more profits. In the second instance, the investor receives a more immediate return on investment via the dividend and capital appreciation of the share market price. Typically, smaller companies attempt to create shareholder value by reinvesting profits, while more mature companies pay out dividends. Neither method is necessarily better, but both rely on the same idea: in the long run, earnings provide a return on shareholders’ investments, and EPS is the metric used to determine the magnitude of this return.
To summarize, earnings means profit, and is often evaluated in terms of earnings per share. Existing and potential shareholders and analysts use EPS to evaluate a company’s performance, to predict future earnings, and to estimate the value of a company’s shares.
In terms of the stock market, EPS is the most important indicator of a company’s financial health. Earnings reports are released quarterly and are followed very closely by the stock market, news media, and company shareholders. It is little wonder that EPS has become such a deeply entrenched metric to evaluate company performance for common shareholders and potential investors (Investopedia, n.d.).
