Earnings per share and the PE ratio

We look at using earnings per share figures when investing, and also how the price-earnings ratio is employed to calculate the value of a company and its shares.

Source: Bloomberg

What is earnings per share (EPS)?

Companies provide investors with regular updates on their progress, and in these reports a number of figures are to be found that help investors and traders gauge the health of a firm. A key number in these updates is the earnings per share (EPS) figure.

Simply put, EPS takes the net earnings of a firm and divides that by the number of shares in issue. So, for example, a company that made £10 million in its financial year, and that has 50 million shares in issue, would have a basic earnings of 20p per share:

£10,000,000 / 50,000,000 shares = 20p per share

This does not mean that each shareholder will receive 20p for each share that they hold. Instead, EPS can be used to gauge the success or failure of a company, depending on what the EPS figure is and whether it has gone up or down over a given period.

Adjusted and diluted EPS

EPS can be found in various forms apart from the basic one above. Adjusted earnings per share will use the adjusted earnings figure (which strips out exceptional costs that are deemed to be non-recurring; these are included in the headline figure but stripped out in the adjusted one in order to provide a truer comparison with the previous period).

Diluted earnings per share, on the other hand, will see all outstanding options held by executives and directors included. As the name suggests, diluted EPS will be smaller since the number of shares included is smaller.

While these figures are seen across earnings reports, when calculating the PE ratio, as we will below, the ordinary EPS figure is used, and investors should not be unduly concerned with these two variations.

Using the PE ratio to calculate earnings per share

EPS can be used to measure the health of a company, or a group of companies, but it has a broader use beyond the figure itself. It is a key variable in the price-earnings (PE) ratio, one of the most commonly used formulas in investing.

The PE ratio is a quick way to measure the value of a company and its shares. It takes the share price and divides it by the EPS figure. For example, a company with a stock price of £10 and EPS of 20p would have a price earnings of 50:

£10 / 20p = 50

A PE ratio can be used to measure whether a company’s shares are ‘cheap’ or ‘expensive’. The higher the PE ratio, the more an investor is willing to pay for each £1 of earnings. In the example above, an investor is paying £50 for each £1, which would seem to be quite a high level. A high PE suggests high growth expectations (think Amazon or Ocado in the UK), while a low PE indicates that only modest growth is expected.

A better way, perhaps, to use a PE ratio is to compare companies within a specific sector. For example, a trader may wish to buy shares in a large mining company. There are several of these listed on the FTSE 100. By comparing PE ratios, he can see which shares are highly valued and which are valued at a relatively low level. Long-term investors might want to buy those shares deemed ‘cheap’ on a PE basis, since the long-term outlook might be brighter. By contrast, a trader with a short-term horizon might prefer ones with a higher PE, since the short-term bounce from strong results will deliver a quicker return.

It is possible for EPS to be negative, although this would technically be a loss per share. A company with a negative EPS will not have a PE ratio. In such cases, other metrics can be used, such as sales growth, or book value, or investors can use a ‘forward’ PE, which takes expected earnings for the next year, or subsequent years, on the assumption that growth will improve in the future.

Why is earnings per share and the PE ratio important to investors?

PE ratios can be used in isolation, as a quick filter on companies. Some investors will want to find ‘growth’ companies, usually smaller firms that are expected to grow quickly. This can see rapid share price growth, but the problem with high expectations is that missing them can generate sharp falls in the shares.

By contrast, ‘value’ investors are hunting for those companies deemed to be ‘cheap’, and thus trading at low PE multiples. When these expectations are beaten, the shares can rally sharply. Both styles of investing have their adherents, and both styles can produce successful results.

Where are company earnings per shares reported?

Earnings per share are reported in Regulatory News Service (RNS) statements, which are released through the London Stock Exchange (LSE). News websites will also cover the figures in an abbreviated form, but reading the company reports directly will help investors to get a feel for overall performance as well as containing the EPS figure.

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