My friends and I often debate the question: if we were stranded on a desert island, which CD would we want to have with us? My choice is always Bruce Springsteen’s Born to Run. It reminds me of being an adolescent, trying to figure out life, while finding a passageway to adulthood. If asked which key piece of financial data I would choose to figure out a company’s profitability, which, by the way, my friends have never asked me, it would be the earnings per share (EPS). This tidbit of corporate data tells the financial story about a company better than any other single record of its performance.
EPS is simple in form, easy to calculate and readily accessible. The Securities and Exchange Commission (SEC), a government agency regulating public corporations, requires these companies to report their EPS quarterly. The announcement from company headquarters usually goes something like this: “Today we are announcing the third quarter Net Income of $3 billion with an EPS of $1.00 per share, which is up 5% from the same quarter of last year.” Let’s examine why investors watch the EPS so closely.
What does the EPS tell us about a company’s performance? This data conveys to the public and the stockholder in particular, how much money a share of stock earned or lost. We’re not talking about the price of the stock in open market (another future article). We are talking strictly about the profit or loss of a company as a result of selling goods and services.
How does a company calculate EPS? This calculation is achieved by dividing the net income (Revenues – Expenses = Net Income) for a given period, by the number of shares of stock in the market place. For example, in the fourth quarter of 2011, Exxon Mobil earned a net income of $9 billion (yes, that’s nine zeros) and had 4.6 billion shares of its stock in the hands of investors. The EPS calculated to $1.97 ($9b/4.6b). In and of itself that number doesn’t tell us too much, except that the company was profitable. You might wonder, and rightfully so, if over time, Exxon Mobil’s profit is increasing or lagging. In comparison to 2011, Exxon Mobil’s EPS for Quarter 4 in 2010 was $1.85 and for the same quarter in 2009 was $1.27. With a comparative view we see an EPS increase of 18%. So, what this data tells an investor is that the company has steadily improved its profitability over the last 3 years.
What do shareholders do with the EPS once they hear it announced? They hurry back to their computer and look up how much they paid for the stock, comparing that amount to the earnings. In total, Exxon Mobil’s EPS was $8.91 for 2011. If you paid on average $50 per share for the stock, while your friend paid $100 per share, you would be feeling pretty good about your investment. Your return on investment for the year was 18% ($8.91/$50), while your friend’s investment only returned 9% ($8.91/$100). Both you and your friend faired far better than you would have with a typical bank savings account with a current interest rate of about one-percent. You were rewarded for your risk taking behavior by investing in an ever changing stock market as opposed to a low interest and virtually no risk option of a bank investment. So, when I’m stranded on that desert island wondering about my financial future, I’ll be blasting Born to Run and waiting for that message in a bottle with the EPS announcements of my favorite stocks.
Trivia Question: In 2010, which company had a higher Earnings Per Share: Coke or Pepsi?
Click on video for the answer to the trivia question along with a short tutorial showing the calculation of EPS for a Maine company” Bar harbor Bank and Trust
Tom Giordano is an Assistant Professor of Accounting at University of Maine at Augusta. He writes on financial literacy concepts with respect to the stock market and provides a short tutorial to compliment each article. His next article will speak to what do companies do with all that money they make in an article titled: Counting on Dividends