When investing in the stock market investors can use two metrics: Earnings per share (EPS) and Price-to-earnings ratio (P/E ratio), to determine how much profit a company generated per share, and whether the share is considered overvalued or undervalued.
What is Earnings Per Share?
Using earnings per share (EPS), investors can calculate how much a company makes per share from the profits it has generated over a period as reported by the company, either annually or quarterly.
You can calculate EPS, by using the number of outstanding shares, which is indicated in the company's financials, divided by the company's net profit.
Take, for example:
- Company A has profits of $500,000, with 10,000 outstanding shares.
- Company B has profits of $700,000 with 40,000 outstanding shares.
Company A EPS will be $500,000/ 10,000 = $50 per share.
Company B EPS will be $700,000/ 40,000 = $17.5 per share.
Using the above example, this indicates to investors that despite huge profits, the determining factor for how much a company makes per share (EPS) also depends on how many shares the company has issued, which may be highly diluted.
Explaining what P/E Ratio means
After calculating a company's EPS and using the company’s trading price from the research period, a P/E ratio reflects whether a company’s share price is overvalued or undervalued and how much investors are willing to pay for the stock relative to its earnings.
While there may not be a standard "good" P/E ratio, in general, companies with a high P/E ratio are usually considered overvalued (where investors are paying more than what the company is making per share) compared to those with a low P/E ratio, considered undervalued (where investors are paying less or close to the company’s earnings).
Let’s look at how that would look for Companies A and B,
After calculating the EPS ratio of Company A and B, which is $50 per share and $17.5 per share - assuming the companies are trading at $100 and $60 per share, respectively.
Calculating P/E ratio
Company A = share price / EPS
$100 / $50= 2 x (P/E ratio)
Company B =share price / EPS
$60 / $17.5 = 3.4 x (P/E ratio)
What this means for companies A and B is that investors are willing to pay x2 times and x3.4 times for the shares of the companies, relative to the earnings.
