Using the Earnings Per Share To Assess The Value Of a Company

There are so many tools that can provide valuable insights into how a company is performing and each one of them assess different areas of the company ranging from dividends to loans, liquidity, and even profitability.

There are so many tools that can provide valuable insights into how a company is performing and each one of them assess different areas of the company ranging from dividends to loans, liquidity, and even profitability. When it comes to assessing profitability, one of the metrics used is the Earnings per Share or EPS. This ratio is a tool that helps investors assess how much profit a company has made and as opposed to just knowing the overall profit for a period, say a quarter, the EPS – just as the name implies – shows you the earnings per every one share.

It represents the part of a company's profit that is allocated to each outstanding share of the company’s ordinary shares. To calculate it, you simply determine total earnings which is essentially the difference between a company’s net income and dividends paid then divide by average number of outstanding shares.

To understand it better, picture this: Assume that a company makes a net profit of 10 million Naira in one quarter. Out of this sum, it decides to reward its investors by paying dividends of 3 million Naira to holders of preference or preferred stock. This gives us 7 million Naira left.

Hold that thought. Now let’s talk about the shares. Let’s say that in the first half of a quarter, the company had 1 million shares outstanding and in the second half, it has 1.5 million shares outstanding. To find the average, you will need to add both (1 million + 1.5 million = 2.5 million shares) and divide by 2. This gives us an average amount of shares of 1.25 million shares. The earnings per share for this company is therefore: 7 million Naira divided by 1.25 million shares and this results in N5.6/ share.

The resulting value is used as an indicator of a company's profitability. The higher the EPS, the higher the figure an investor is said to be willing to pay for the stock. As such, a higher EPS serves as an indicator for more value as investors will naturally pay more for a company with higher profits.

The idea behind the EPS is that as earnings increase, stock prices too increase because people now see more value in it as investors earn more. When comparing with other companies, higher EPS shows higher profits as the higher ones signify that there is more money for the company to either distribute to investors or reinvest.

Just like other ratios, the EPS cannot be used in isolation. While it shows profitability, it doesn’t show other metrics that have been used to increase the profitability. In other words, if the company is highly leveraged and caught up with debts but still making profits, the EPS does not show the debt part. So two companies could have the same EPS and one used more money to get it and the other used less. It is the job of the investor to figure out and opt for the one managing its resources better. Also, being that companies can repurchase its shares, they can manipulate the figure of the EPS by reducing shares outstanding. The EPS is undoubtedly a good tool for assessing profitability of a stock; it is, however, important to consider all other relevant factors as well.

Written by Lawretta Egba.