Hey, That's A Great EPS You've Got There!

Last summer I wrote a few posts to help you dip your toes into the shallow waters of investment jargon. You might (or might not) find the jargon useful, but there is a lot to be said for not feeling like you are in over your head when discussing your own investments. So today, I've dragged out a slightly fusty standby—Earnings Per Share, or as its friends know it, EPS. Like many bits of financial knowledge, EPS is supposed to help you spot the best investments. Quite simply, it refers to the net earnings (how much the company in question is taking in per year) divided by the number of shares outstanding. Here is an example:

Walnert, Inc., a company whose shares are traded publicly on the open market, earned a paltry $8 million last year. The company has 4 million shares outstanding. Its EPS is $8 million ÷ 4 million, or 2. Theoretically, this means that, if you own just 1 share of Walnert, about $2 bucks of the company's profits for the year belong to you.

EPS gives us one way to compare company stocks that are otherwise pretty similar—all else being equal, I'd rather buy the stock that gets me $6 per share than the one that gets me $2 per share. But, of course, you don't actually get $2 or the $6. In fact, you won't necessarily get anything even if you sell your share.

Why? Because the share price changes day to day based on what other investors think the stock is worth. And that belief is based on predictions. How much the company is earning now is a nice bit of data, but what investors really want to know is, will the company keep earning this much? Will it earn more (or less)? And even if it does earn more next year, might there be some reason to fear for its future? More importantly still, will other investors fear for its future?

When I value an investment, I am really making a judgement about how other investors will feel about my investment in the future (when I am ready to sell). Believe it or not, I don't actually care how well the company does—as long as someone else will pay more for my stock than I did, I've invested successfully.

Unfortunately, investors are people and people are...unpredictable. I have a client who has been waiting for his solar company stock to go up for some time. The company's profits have grown, the industry is overtaking other types of energy, and one of its biggest competitors recently failed. So far, investors have concluded from all of this that solar companies can fail, and as a result the stock price refuses to go up. What is an investor to do? Well, this brings us back to Earnings Per Share.

Trying to anticipate what other investors will do in the future is frustrating at best and impossible at worst. But if the EPS suggests that your share price is a better "bargain" than the stock price at a comparable company, you can reasonably hope that, eventually, other investors will notice the same thing and start playing along.