While deciding between the companies operating in the same sector, examine the rate at which the EPS of these companies has changed during the final two quarters and compare this difference with the rate of change of EPS during the last 3-5 years. If the EPS has shown an increase, it would mean the company is on the growth path. It will give you an idea of which of the companies under consideration would give you the best possible returns.
Looking to buy stocks or mutual funds? Wondering how to choose the right ones that will help you get good returns on your investment? If you are looking for the answers to these questions, then you must understand the concept of financial ratios. Financial ratios such as ROA, ROE, ROI, PE, EPS etc. give you an idea of how your investment will fare in the selected stock or fund. As a result, they form a crucial part of an investment decision. One of the most important amongst them is EPS – Earnings per share. Companies must report both, the basic EPS as well as diluted EPS in the financial reports.
Definition of EPS
EPS or earnings per share is a ratio that denotes the profitability and success of a company on the basis of per share. It is calculated as EPS =Net Profit (loss) – Dividends of preference shares / weighted average of number of shares available at a certain point of time. The number of available shares can differ due to the company buyback of shares, rights and bonus issues, conversion of debt into equity etc. This can ultimately dilute the value of your holdings. So in order to take these variations into account, the notion of diluted EPS was developed. There can be difference in the actual EPS and diluted EPS. E.g. if the EPS of the stock is Rs. 5, and the company issues bonus shares in the ratio of 1:1, the no of shares available increases. This in turn will reduce the EPS of the share. Hence you must have knowledge of how your earnings will be affected, if the equity is diluted. As a result, the companies report trailing EPs, which is the EPS calculated from the company’s earning in the previous year. Sometimes, the company may use terms like current and forward EPS, which are derived on its expected earnings.
Usage of EPS
EPS is an important factor when taking an investment decision. But it shouldn’t be used as a stand alone indicator of company’s performance. It should be used to compare the company’s operating in the same industry, e.g. TCS and Infosys. But don’t try to compare the EPS operating in different sectors e.g. Tata Motors and Reliance Capital. While deciding between the companies operating in the same sector, examine the rate at which the EPS of these companies has changed during the final two quarters and compare this difference with the rate of change of EPS during the last 3-5 years. If the EPS has shown an increase, it would mean the company is on the growth path. It will give you an idea of which of the companies under consideration would give you the best possible returns. E.g. if the EPS of HUL is Rs 3 and of ITC is Rs 4, ITC will give you far better returns on your investment than HUL.
Drawback of EPS
While EPS does indicate the return you will get from the stock, it does have its own share of limitations. EPS uses the past data for calculation. But this does not mean the company will be able to generate the similar kind of returns in the future. Moreover as was the case in Satyam, this type of data is open to manipulation.
EPS is one of the important ratios in taking investment decision. But it should not be used as a standalone measure of company’s performance. It should be considered along with other ratios, company’s growth prospects and its management background. Also remember EPS will change if the company’s equity base changes. Also different sectors will have different EPS. It is advisable to compare the companies in the same business to get a clear picture of the company’s performance.