A company’s earnings are the reason for its existence, and is defined as the revenue minus the cost of sales, operating expenses, and taxes. In simpler terms it’s how much profit the company made. As value investors, we are very concerned about a company’s earnings (or lack thereof) as earnings figure greatly in determining a company’s value. It only makes sense that a company with a very high probability of increasing it’s profit year after year is more valuable than one in which earnings growth is stagnant or even declining. Companies generally report their earnings quarterly, and it’s not uncommon to see share prices rising or falling rapidly after the announcement, particularly if the result was unexpected.
Why do we care about earnings?
Or more specifically, why do we care about earnings growth? As investors we typically want to see the companies we invest in grow. To effectively accomplish that goal money is required, so companies with earnings that grow higher every year have more money to invest in their growth. This could take the form of the purchase of new factories, hiring of new employees, expansion into new markets, or additional research & development of new products to name a few. Companies can also take on debt to finance growth, however at some point debt becomes so high that this is no longer practical, and earnings are still required in the future in order to pay off the debt.
We therefore care about earnings because it’s a great indicator of future company growth – and growth often means an increase in share price. If the company’s management feels that they cannot invest earnings in a way that will produce adequate returns, the company may opt to commence or increase dividend payments to shareholders. In both cases earnings are a good thing for investors, as it ultimately means an increase to our bottom line.
Company size that is. Let’s say that company XYZ earned $1,000,000 last year. Is that a lot? Could they have done better? Sure, a million dollars may sound like a lot to you and me, but it means nothing without knowing the size of the company. A company that’s worth $5 million would be doing very well to earn $1 million per year. However a company worth $5 billion wouldn’t be doing so hot. The size of companies is measured by what’s called it’s market capitalization, and is calculated as follows:
Market cap = (Price per share) x (# shares outstanding)
Let’s look at Microsoft for example. As of today’s writing, Microsoft was trading at $27.68 per share. Microsoft currently has 8.42 billion shares outstanding. We multiply these two numbers together to arrive at a market capitalization (market cap for short) of $233 billion! In other words, this is the amount it would cost if you could convince every other shareholder of the company to sell you their shares at the current market price of $27.68.
How to calculate EPS
Let’s take it a step further now and look at earnings. Just as share price is meaningless when determining the market cap of a company until the number of shares are figured in, the same holds true for earnings. It is much more useful to look at earnings on a per share basis, so that there’s an equal playing field when comparing earnings of different companies. Earnings per share is usually abbreviated to EPS and is calculated as follows:
EPS = (Net Earnings) / (# shares outstanding)
Let’s again look at Microsoft. Last year (2012) Microsoft had net earnings of $16.98 billion. If we divide that by the same 8.42 billion shares outstanding that we used above, we arrive at an EPS of $2.02. This is a much more useful number that earnings on its own. Now we have a basis that we can use to compare with other companies, and we can calculate other useful metrics such as the PE ratio (Price / Earnings ratio).
Where to find EPS data
To calculate EPS, the only information we need is the company’s earnings and number of shares outstanding. This information is readily available within every company’s income statement, and is also summarized in a number of online stock market research websites that are available for free. Let’s look at an income statement first. Following is Microsoft’s income statement for 2012, included in their annual report. It can be found here.
The income statement contains all of the information we need to calculate EPS…. actually we don’t even need to – they calculate EPS for us! Earnings in this case is referred to as net income and is listed on the income statement as $16,978 million. It’s usual for income statements to list all numbers in millions for consistency. The number of shares outstanding is listed under Weighted average shares outstanding. Note that there’s two numbers here, a Basic and a Diluted. We’ll get into the difference between these below. Using the basic shares results in an EPS of $2.02 as we calculated previously, and using the diluted number results in a slightly lower EPS of $2.00. Note that both of these EPS values are calculated for us on the income statement itself under Earnings per share.
There has to be a more efficient way of obtaining these values than sifting through annual reports. There is. There’s a whole host of websites that gather and summarize this information for you. Let’s look at one of my favorites – msn Money. The msn Money website can be found at http://money.msn.com. Let’s go there now and pull up the information on Microsoft stock by entering the stock ticker MSFT.
Out pops the income, shares outstanding, and even a calculated EPS number just as we wanted, all contained a little down the page under the Financial Highlights section. But wait – the EPS shown here is only $1.85! Why is it different? Notice the asterisk (*) beside the income value of 15.71 billion, and the note at the bottom “last 12 months”. The income numbers in the annual report were as of the fiscal year end 2012. The information on the msn money website however is as of the most recent quarterly report. This is sometimes referred to as the trailing twelve months and abbreviated to ttm. It’s the most current information available, but it’s important that you realize where the data comes from. Annual data is also available on msn money, just in a different area:
- Go to msn Money and enter in the stock ticker (MSFT in this case)
- Click on 10-Year Summary found in the menu in the left hand column
- Earnings and EPS for each of the last 10 years are listed under Total net income
- Shares outstanding for each of the last 10 years is listed under Shares outstanding
Here’s a screen shot:
What’s the difference between Basic and Diluted EPS?
We saw above that the income statement listed two numbers for shares outstanding. There was a number for both Basic, and a slightly higher number for Diluted. These translated into two separate values for EPS – again both a Basic and a Diluted dollar amount. What is the difference between these two?
The basic number of shares outstanding is essentially the true number. There is physically this number of shares in existence at this moment. The diluted number takes into account other investment vehicles which could become additional shares at some point in the future – most notably stock options, warrants, and convertible bonds – if all of these were to be exercised. In this respect, the diluted EPS value is really a worst case scenario number of shares. Assuming that the earnings stays the same, the worst case EPS would be based on using the diluted number of shares outstanding. For conservative calculations, the diluted EPS is therefore most commonly used.