Fundamental Analysis: Earnings Per Share and Price Earnings Ratio

Submitted by Sharemarket News on 13 May, 2011 - 18:19

Learn about earnings per share and price earnings ratio.

Earnings Per Share

Earnings per share (EPS) is a part of the company profit allocated to each outstanding share and indicates a company's profitability. The EPS value is used to calculate price to earnings ratio. The formula for EPS is net profit after tax (NPAT) divided by number of shares on issue, with the results expressed as cents per share.

EPS (cents per share) = Net profit after tax ÷ Number of shares on issue.

EPS is considered to be an important factor in determining share price, however, the EPS figure on its own does not mean much. Net profit after tax should be taken into account. After EPS is determined, trends should be analysed. Is EPS rising or falling, and how different is the value from the previous periods? What caused the difference in value?

Let's say company Miners R Us (MRU) has 25 shares outstanding and Seven Dwarfs Mining (SDM) has 65 shares outstanding. Both have earnings of $250. Using the above formula, EPS for MRU will be 10, while SDM has an EPS of 3.8. Since the two companies are in the same industry (mining), it is better to buy stocks from MRU than SDM.

Traders, however, should not rely on EPS data alone when deciding which stock to purchase, particularly for companies in different market sectors.

Price to Earnings Ratio (PE Ratio)

Price earnings ratio tells you how many times it will take for the stock you purchased to be covered by earnings. PE also tells you how much investors are willing to pay per dollar of earnings. Usually, PE is calculated using EPS from the last four quarters, also known as trailing PE. The formula is:

PE Ratio = Share Price ÷ EPS

For example, Seven Dwarfs Mining (SDM) has a share price of $20 with an EPS of 5. The PE ratio is 4. Miners R Us (MRU) has a share price of $20 with an EPS of 8. PE ratio is 2.5. This tells the investor that SDM is a better buy than MRU. A high PE ratio suggests that a company expects growth and high profits, which means the market is more willing to pay for the company's earnings. A low PE indicates the opposite: slow growth and no profits.

It is wise to pick stock SDM rather than MRU since in this particular case there are from the same sector, mining. Some traders read a high PE as overpricing, but it can also indicate that the market thinks that the stock will rise in value in the future, and so has bid up the price. A low PE, on the other hand, can be read as a stock without value or simply a stock that has not realised its potential just yet.

As with any investment decision, do not depend on EPS alone to determine if a stock is a good purchase. To get an accurate picture, compare the PE ratio to other companies within the same sector and to the market as a whole.