Must-read before using EPS for stock selection: This indicator is not as simple as you think

Investors often hear news like “Company X’s EPS hits a new high,” and it seems that earnings per share (EPS) is the key indicator for judging whether a stock is good or not. But in reality, if you only use EPS to pick stocks, you might fall into a trap.

What exactly is Earnings Per Share?

Earnings Per Share (EPS) is the English term, straightforwardly meaning: how much profit the company earns per share of common stock.

This data measures the company’s profitability—generally, the higher the EPS, the stronger the company’s earning ability. Apple (AAPL.US) has seen its EPS steadily rise over the past 20 years, reflecting the continuous growth in company value.

For investors, EPS is a common tool to evaluate a company’s worth. If you believe a company’s profit is more attractive relative to its stock price, you are more willing to bid higher. Investors also use EPS to compare companies within the same industry to determine which has greater value.

How to calculate EPS? One simple formula does the trick

Calculating EPS requires three data points:

• Net Profit: the profit after deducting all expenses from revenue, usually at the bottom of the income statement
• Preferred Dividends: dividends paid to preferred stockholders at a fixed rate, also listed at the bottom of the income statement
• Outstanding Common Shares: issued common shares minus treasury shares, reflected in the shareholders’ equity section of the balance sheet

Calculation formula: EPS = (Net Profit - Preferred Dividends) ÷ Outstanding Common Shares

Taking Bank of America (BAC.US) 2022 financial report as an example:

• Net Profit: $27.528 billion
• Preferred Dividends: $1.513 billion
• Outstanding Shares: 8.1137 billion shares
• Result: (27.528 - 1.513) ÷ 8.1137 = $3.21 per share

In fact, most financial reports already list “Net Income attributable to common shareholders” separately, so investors can directly divide that number by the number of shares outstanding for convenience.

Two quick ways to find EPS

Method 1: Review the financial report (most accurate) Visit the SEC website (sec.gov), search for the company’s 10-K annual report or 10-Q quarterly report, and find EPS data in the income statement.

Method 2: Check market data websites (most convenient) Platforms like SeekingAlpha, Yahoo Finance, etc., provide EPS data. Be aware that they often present multiple types of EPS (basic EPS, diluted EPS, forecasted EPS, etc.), so confirm which one you need.

Since data on these sites may be scraped and less accurate than official filings, for important investment decisions, always rely on the official financial reports.

Why must investors pay attention to EPS?

EPS is linked to a more important metric—the Price-to-Earnings Ratio (P/E ratio), calculated as: stock price ÷ EPS.

This ratio connects the company’s fundamentals with the stock market price, helping investors understand how much they are paying for each dollar of profit. For example, Nvidia (NVDA.US) recently saw its EPS decline, but due to optimistic outlooks, its P/E ratio soared to 135.9, indicating investors are willing to pay a premium for its future growth.

The real relationship between EPS and stock price: not simply positive correlation

Generally, strong EPS tends to push stock prices higher, driven by a virtuous cycle: higher stock price boosts investor confidence → sales grow → profits increase → EPS rises → attracts more investors → stock price continues to rise.

But this relationship is not absolute. The key variable is market expectations:

• If EPS exceeds Wall Street estimates, even if the data declines, the stock may still rise
• If EPS falls short of expectations, even if the data improves, the stock may decline

Nvidia’s case is typical: in February earnings, EPS declined quarter-over-quarter, but revenue and EPS beat expectations. Plus, management’s positive signals during the earnings call caused the stock to jump 14% overnight.

Beware of three EPS traps, or you’ll definitely stumble in stock picking

Trap 1: Stock buybacks artificially inflate EPS

Suppose a company’s net profit remains unchanged, but through buybacks, the number of shares outstanding decreases, making the denominator smaller, thus boosting EPS. If you don’t notice the shrinking share count, you might be fooled into thinking the company’s profitability is improving.

Trap 2: Special items distort the data

Non-operating events like asset sales, business divestitures, or tax subsidies can temporarily boost profits. For example, Yum! Brands (YUM.US) reported losses from exiting the Russian market, which is a typical case. These one-time items won’t recur, so ignoring them can lead to an inaccurate assessment of the company’s sustainable profitability.

Trap 3: Looking at single-period EPS alone is meaningless

EPS for a single quarter or year is isolated. Only by examining long-term trends—whether EPS is consistently growing, stable, or declining—can you assess the company’s true investment value.

Basic EPS vs Diluted EPS: what you need to know

Financial reports usually show two EPS figures:

Basic EPS = (Net Profit - Preferred Dividends) ÷ Current Outstanding Shares Reflects the company’s current true profitability.

Diluted EPS = (Net Profit - Preferred Dividends) ÷ (Outstanding Shares + Potentially Dilutive Securities) Considers a hypothetical scenario where all options, restricted stocks, convertible bonds, etc., are converted into common shares, showing the worst-case dilution effect on EPS.

For example, Coca-Cola (KO.US) has 4,328 million shares outstanding, and 22 million potential dilutive securities, with net profit of $9,542 million. The diluted EPS would be 9542 ÷ (4328 + 22) = $2.19.

Diluted EPS is more valuable for investors because it reflects the company’s profitability under the worst-case scenario where all potential shares are converted.

How to use EPS to truly pick good stocks?

Step 1: Focus on trends, not absolute values Compare long-term EPS trends. If EPS grows year after year, the company’s profitability is improving; if it declines persistently, beware.

Step 2: Benchmark against peers Compare the target company’s EPS with industry competitors. But remember, don’t just look at absolute EPS; consider the P/E ratio. For example, if Company A’s stock is $30, EPS is $1 (P/E 30), while the industry average P/E is 10, the market is pricing A with a high premium, indicating potential overvaluation.

Step 3: Deep dive into the numbers Check whether EPS growth comes from genuine profit increases or from tricks like stock buybacks or special gains. Compare net profit growth rate with EPS growth rate—if EPS grows much faster than net profit, buybacks are likely at play.

Step 4: Combine with other indicators and outlooks EPS is important but not everything. Also consider cash flow, debt levels, industry prospects, competitive advantages, etc. Since 2020, Qualcomm’s EPS has been much higher than Nvidia and AMD, but Nvidia’s 3-year return is 251%, compared to Qualcomm’s 69%, because the market favors Nvidia’s long-term prospects.

What else should you know: the relationship between EPS and dividends

Earnings per share (DPS) indicates how much cash the company distributes per share annually. EPS measures how much the company earns, while DPS shows how much is paid out to shareholders.

High dividends sound attractive, but paying too much can leave insufficient funds for R&D, expansion, and growth investments, which may slow EPS growth in the long run. That’s why high-growth tech companies often pay little or no dividends, reinvesting profits instead.

FAQs

Q: How much EPS is considered good?
Looking at the absolute value alone is meaningless. Focus on: (1) whether EPS has been steadily rising over the long term; (2) whether it is higher than industry peers; (3) whether EPS growth stems from genuine profit increases.

Q: Can EPS be forecasted?
Yes. Wall Street analysts forecast future profits, producing forward-looking EPS. Investors compare actual EPS with expectations to gauge market sentiment.

Q: Why might I still pick poor stocks despite looking at EPS?
Because no single indicator can tell you everything about a stock. EPS is just one aspect. When selecting stocks, consider competitive advantages, industry position, financial health, management quality, and long-term growth potential.