Earnings Per Share (EPS)

Earnings
Earnings Per Share (EPS) =
Numbers of Shares Outstanding

Earnings per share is generally considered to be the single most important variable in
determining a share's price.

For example, assume that a company has a net income of $25 million. If the company pays out $1
million in preferred dividends and has 10 million shares for half of the year and 15 million shares
for the other half, the EPS would be $1.92 (24/12.5). First, the $1 million is deducted from the net
income to get $24 million, then a weighted average is taken to find the number of shares
outstanding (0.5 x 10M+ 0.5 x 15M = 12.5M).

An important aspect of EPS that's often ignored is the capital that is required to generate the
earnings (net income) in the calculation. Two companies could generate the same EPS
number, but one could do so with less equity (investment) - that company would be more
efficient at using its capital to generate income and, all other things being equal, would be a
"better" company.

How to Evaluate the Quality of EPS

The best way to evaluate quality is to compare operating cash flow per share to reported EPS.
If operating cash flow per share (operating cash flow divided by the number of shares used to
calculate EPS) is greater than reported EPS, earnings are of a high quality because the
company is generating more cash than is reported on the income statement. Reported (GAAP)
earnings, therefore, understate the profitability of the company.

If operating cash flow per share is less than reported EPS, it means that the company is
generating less cash than is represented by reported EPS. In this case, EPS is of low quality
because it does not reflect the negative operating results of the company and overstates what
the true (cash) operating results.

Cash Flow Per Share

Operating Cash Flow – Preferred Dividends
Cash Flow Per Share =
Common Shares Outstanding

Operating cash flows concentrate on cash inflows and outflows related to a company's main
business activities, such as selling and purchasing inventory, providing services and paying
salaries. Any investing and financing transactions are excluded from operating cash flows and
reported separately, such as borrowing, buying capital equipment and making dividend
payments. Operating cash flow can be found on a company's statement of cash flows, which
is broken down into cash flows from operations, investing and financing.
 Price-Earnings Ratio - P/E Ratio
Market Value per Share
PE =
Earnings per Share (EPS)

For example, suppose that a company is currently trading at $43 a share and its earnings over the
last 12 months were $1.95 per share. The P/E ratio for the stock could then be calculated as
43/1.95, or 22.05.

In general, a high P/E suggests that investors are expecting higher earnings growth in the
future compared to companies with a lower P/E. A low P/E can indicate either that a company
may currently be undervalued or that the company is doing exceptionally well relative to its
past trends. When a company has no earnings or is posting losses, in both cases P/E will be
expressed as “N/A.” Though it is possible to calculate a negative P/E, this is not the common
convention.

An individual company’s P/E ratio is much more meaningful when taken alongside P/E ratios
of other companies within the same sector.

Things to Remember

• Generally a high P/E ratio means that investors are anticipating higher growth in
the future.

• The average market P/E ratio is 20-25 times earnings.

• The P/E ratio can use estimated earnings to get the forward looking P/E ratio.

• Companies that are losing money do not have a P/E ratio.

 Debt/Equity Ratio
Total Liabilities
Debt - Equity Ratio =
Shareholders' Equity

Given that the debt/equity ratio measures a company’s debt relative to the total value of its
stock, it is most often used to gauge the extent to which a company is taking on debts as a
means of leveraging (attempting to increase its value by using borrowed money to fund
various projects). A high debt/equity ratio generally means that a company has been
aggressive in financing its growth with debt. Aggressive leveraging practices are often
associated with high levels of risk. This may result in volatile earnings as a result of the
additional interest expense.

For example, suppose a company has a total shareholder value of $180,000 and has $620,000 in
liabilities. Its debt/equity ratio is then 3.4444 ($620,000 / $180,000), or 344.44%, indicating that the
company has been heavily taking on debt and thus has high risk. Conversely, if it has a shareholder
value of $620,000 and $180,000 in liabilities, the company’s D/E ratio is 0.2903 ($180,000 /
$620,000), or 29.03%, indicating that the company has taken on relatively little debt and thus has
low risk.

If a lot of debt is used to finance increased operations (high debt to equity), the company
could potentially generate more earnings than it would have without this outside financing. If
this were to increase earnings by a greater amount than the debt cost (interest), then the
shareholders benefit as more earnings are being spread among the same amount of
shareholders. However, if the cost of this debt financing ends up outweighing the returns that
the company generates on the debt through investment and business activities, stakeholders’
share values may take a hit. If the cost of debt becomes too much for the company to handle,
it can even lead to bankruptcy, which would leave shareholders with nothing.

Like with most ratios, when using the debt/equity ratio it is very important to consider the
industry in which the company operates.

Another important point to consider when assessing D/E ratios is that the “Total Liabilities”
portion of the formula may often be determined in a variety of ways by different companies,
some of which are not actually the sum of all of the company’s liabilities. In some cases,
companies will only incorporate debts (like loans and debt securities) into the liabilities
portion of the formula, while omitting other kinds of liabilities (unearned revenue, etc.). In
other cases, companies may calculate D/E in an even more specific way, including only long-
term debts and excluding short-term debts and other liabilities. Yet, “long-term debt” here is
not necessarily a term with a consistent meaning. It may include all long-term debts, but it
may also exclude long-term debts nearing maturity, which are then categorized as “short-
term” debts. Because of these differentiations, when considering a company’s D/E ratio one
should try to determine how the ratio was calculated and should be sure to consider other
ratios and performance metrics as well.
 Investment Valuation Ratios: Price/Earnings To
Growth Ratio (PEG)
Price to Earnings Ratio (PE)
PEG =
Annual EPS Growth

The general consensus is that if the PEG ratio indicates a value of 1, this means that the
market is correctly valuing (the current P/E ratio) a stock in accordance with the stock's current
estimated earnings per share growth.

If the PEG ratio is less than 1, this means that EPS growth is potentially able to surpass the
market's current valuation.

In other words, the stock's price is being undervalued. On the other hand, stocks with high
PEG ratios can indicate just the opposite - that the stock is currently overvalued.

Example:

Let’s try to figure out Apple Inc.’s (AAPL) “valuation relative to growth” if for example its annual
growth rate is 20%, and its current P/E ratio is 8.

PE = 8
PEG = = 0.4
Annual EPS Growth Rate = 20

Since the PEG value that we got here is less than 1, we can assume that it is undervalued relative to
its growth and is a promising candidate for a buy, but only upon further evaluation of other
fundamental factors.

This ratio is a quick tool for checking a company’s “value relative to growth”. If the PEG ratio is
below 1, then the price is considered “cheap” relative to its growth and if it is above 1, you are
paying “extra” for that growth. Keep in mind though, that this is just a rule of thumb. You
should check for the consistency and reliability of the company’s earnings growth over the
past few years before making any buy or sell decisions.
 Return on Equity (ROE)
Net Income
Return on Equity (ROE) =
Shareholder's Equity

Net income is for the full fiscal year (before dividends paid to common stock holders but after
dividends to preferred stock.) Shareholder's equity does not include preferred shares.

Example: Apple Inc. has reported Net Income of $25.9 Billion for 2011 and total Stockholder’s
Equity is at $76.6Billion. The return on equity is computed as:

Net Income = $25,900,000,000

Return on Equity (ROE) = = 33.81
Shareholder's Equity = $76,600,000,000

What this means is that Apple Inc.’s management can earn 33.81 cents for every shareholder
dollar invested.

It is wise to compare a company’s ROE to others in the same sector because the company
with higher ROE means it is more profitable, and that is where we want to put our money on.
It would also be wise to compare a company’s ROE to the returns offered by US government
Treasury bonds. If a company’s ROE is less than that offered by the Treasury bonds, then
investing in that company may not be worth the risk at all.

Return On Capital Employed (ROCE)

Return on capital employed (ROCE) is a financial ratio that measures a company's profitability
and the efficiency with which its capital is employed.

Earnings Before Interest and Tax (EBIT)

ROCE =
Capital Employed

“Capital Employed” as shown in the denominator is the sum of shareholders' equity and debt
liabilities; it can be simplified as (Total Assets – Current Liabilities).
 Price-To-Book Ratio - P/B Ratio
Market Price per Share
P/B Ratio =
Book Value per Share

Total Assets - Total Liabilities

Book Value per Share =
Number of shares outstanding

Example:

If for example Apple Inc.’s book value per share is at $96.6 and the current stock price is at $600.
The Price to Book Ratio would be computed as:

P/B Ratio = $600 / $96.6 = 6.21

This means that the market is paying 6.21 times the book value per share at the current price of
$600.

A P/B ratio of 1 could mean that the stock price is reflecting just the book value and this could
be a real discount. However, it could also mean that something is fundamentally wrong with
the company and that is why people are selling it down. Always make sure to check other
fundamentals instead of relying on just a single ratio alone. This ratio also gives some idea of
how much you’re paying for what would be left if the company went bankrupt immediately.