Profitability is the most critical factor determining the success of a business. While companies can attain some success even when unprofitable, the business will eventually fail if profitability is not achieved. This is why investors pay close attention to financial disclosures forms like 10-Q and 10-K. These reports provide insight into an issuer’s earnings (profits).
Issuers primarily report their profitability through earnings per share (EPS), which is calculated through this formula:
As we discussed previously, a company’s net income is calculated by subtracting business costs (e.g., cost of goods sold, operational expenses, taxes, etc.) from gross revenue. A company is profitable if it still has leftover revenue after paying for business costs (net income). From there, the issuer subtracts preferred dividends to determine the earnings available to common stockholders.
The denominator (bottom of the formula) accounts for the number of outstanding shares. This component can be introduced in one of two general ways. It can be accounted for simple by measuring the number of outstanding shares at a specific point in time (e.g., at the end of the year). This would calculate an issuer’s basic EPS.
Conversely, the outstanding shares can be calculated on a fully diluted basis. This method also accounts for the number of shares outstanding at a specific point, but additionally adds shares waiting to be attained through the exercise or conversion. In particular, it includes shares that employees may gain through stock option exercises and shares that investors may obtain through conversions of convertible preferred stock and bonds. This would calculate an issuer’s fully diluted EPS.
EPS can also be used to determine if a company is over or undervalued. Most investors analyze this by calculating an issuer’s price to earnings (PE) ratio, which utilizes EPS in its formula:
The higher the PE ratio, the more likely the stock is overvalued. For example, if the PE ratio is 100, the company’s market price is 100 times its annual earnings. Unless the company is poised to grow considerably, this investment may be overpriced. On average, PE ratios range between 15-25, depending on the company and industry.
Growth companies typically maintain higher PE ratios. These companies have an evolving and expanding business and are expected to make larger profits in the future. Therefore, the investment may seem “overpriced” today, but it may be a good deal in the long term.
Value companies typically maintain lower PE ratios. These are companies that are large, well-established, and with a long track record of profits. Given their large size, many investors don’t expect value companies to increase their business significantly. Investors are generally unwilling to “overpay” for a value stock without a reason to bet on significant future growth, leading to lower PE ratios.
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