EPS & PE ratio

Profitability is a key driver of long-term business success. A company can operate for a while without profits, but if it can’t become profitable, it will eventually run out of resources and fail. That’s why investors pay close attention to financial disclosure forms like 10-Q and 10-K. These reports provide insight into an issuer’s earnings (profits).

Issuers commonly report profitability using earnings per share (EPS), which measures profit on a per-share basis. EPS is calculated using this formula:

$\text{EPS}=\frac{\text{Net income - preferred dividends}}{\text{Outstanding shares}}$

As we discussed previously, a company’s net income is calculated by subtracting business costs (e.g., cost of goods sold, operating expenses, taxes, etc.) from gross revenue. If revenue remains after paying these costs, the company has positive net income (it’s profitable). From there, the issuer subtracts preferred dividends to determine the earnings available to common stockholders.

The denominator (the bottom of the formula) reflects the number of outstanding shares. Companies generally handle this in one of two ways:

• Basic EPS uses the number of outstanding shares at a specific point in time (for example, at year-end).

• Fully diluted EPS starts with shares outstanding at a specific point in time, then adds shares that could be created through exercise or conversion. In particular, it includes shares that employees may receive by exercising stock options and shares that investors may receive by converting convertible preferred stock and bonds.

EPS is also used in valuation. Many investors compare a stock’s market price to its earnings by calculating the issuer’s price to earnings (PE) ratio, which uses EPS in its formula:

$\text{PE ratio}=\frac{\text{Common stock market price}}{\text{EPS}}$

In general, a higher PE ratio suggests the stock may be more expensive relative to its earnings. For example, if the PE ratio is 100, the market price is 100 times the company’s annual earnings. Unless the company is expected to grow significantly, the stock may be overpriced. On average, PE ratios often range between 15-25, depending on the company and industry.

Growth companies typically have higher PE ratios. These companies are expanding and are expected to generate larger profits in the future. As a result, the stock may look “overpriced” based on current earnings, but investors may be willing to pay more today for expected future growth.

Value companies typically have lower PE ratios. These companies are often large, well-established, and have a long history of profits. Because investors may not expect dramatic growth from mature companies, they’re generally less willing to pay a high multiple of current earnings, which tends to keep PE ratios lower.