Earnings per share (EPS) and Price earnings (PE) ratio

Earnings per share (EPS)

Earnings per share are the earnings returned on the initial investment amount. It is the portion of the profit earned for every ordinary share on issue. EPS shows at a glance the growth in earnings from one year to the next and the relative size of earnings to dividends. Knowing the earnings per share is essential for calculating our next topic, the Price Earnings ratio. EPS is calculated by taking the net profit, assuming there is any, and dividing it by the number of ordinary shares on issue. See the formula below:

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

The EPS figure by itself has little significance. A company may not pay this amount out as a dividend or it could include non-recurring items. It is crucial that when analyzing this information to look at net profit after tax before any of these non-recurring times referred to as “abnormal items”. After calculating the current EPS, you want to look for trends. Has the EPS been rising or falling, and how much of this is from normal operations rather than one-time events? If the EPS is about the same as last year, has there been an increase in the shares on issue?

Keep in mind that EPS doesn’t lend itself to the characteristic of ‘quality’. Analysts look much more closely at the quality of earnings during bear markets and are quick to dismiss one-off items.

Price earnings ratio – PE ratio

The PE ratio is simply the share price divided by the earnings per share (EPS). See the formula below:

PE ratio= (Share price)/EPS= years taken by earnings to cover price

The price earnings ratio shows how much time, in years, it will take for your share purchase to be covered by earnings. The PE ratio reflects the market’s view of the potential earnings of a company. A low PE ratio suggests that the market is expecting lower profits or no growth, and a high PE ratio suggests that the shares market is expecting high growth and a higher profit. You want to compare the PE ratio of shares to buy in a company you are considering to that of other companies in the same sector and in the Australian share market as a whole.

Conclusion:

This concludes the basics of our shares fundamental analysis tutorial. We will add more in-depth topics as time allows, but for now you should have a basic understanding of what goes into fundamental analysis and why it is important. Here are some further points to consider:

When you buy shares in a company you are becoming a part owner of that business.
If you wish to make informed decisions regarding the business you now partially own, it is essential that you understand how that company operates and what is future prospects are.

The best way to understand a company is to read its shares annual report; this is one of the most important publications any company releases to the market. By analyzing the annual report you gain the ability to construct a clear picture of how the company in question has performed over the last 12 months, as well as what its prospects for future growth might be.

To effectively compare the annual reports and prospects from multiple companies, you can use commonly used financial ratios, some of these include dividend per share, dividend yield, PE ratio and earnings per share.