Introduction: The Pizza Party Problem
I want you to picture something for a second.
Imagine you and three friends decide to throw a pizza party. You all chip in some money to buy the ingredients like dough, cheese, and pepperoni. You spend all afternoon tossing dough, baking pies, and selling slices to the neighbors.
At the end of the day, after you have paid for the ingredients and maybe a little gas money for the delivery driver, you have a pile of cash left on the table. That cash is your profit.
Now here is the big question. How much of that cash actually belongs to you?
It depends on how many shares of the pizza party you own. If you and your friends split the work equally, you split the profit equally. However, if you put in half the money and your friends only put in a little bit, you expect a bigger slice of that cash.
This is exactly what investing in the stock market is like. That slice of the cash that belongs to you is what we call EPS or Earnings Per Share.
If you have been looking at stock charts or reading financial news on your phone, you have probably seen EPS pop up a dozen times. It usually sits right next to the stock price. It looks boring and technical. I am going to let you in on a secret though. EPS is probably the single most important number for a new investor to understand.
Why is it so important? Because it tells you if the company you just gave your hard earned money to is actually doing anything with it.
In this post, we are going to break down exactly what EPS is, why the pros obsess over it, and how you can use it to spot a good investment without needing a degree in finance.
What Actually is EPS?
Let us strip away the Wall Street jargon.
When you buy a stock, let’s say you buy one share of Apple or Coca-Cola, you are buying a tiny piece of ownership in that company. You are a partial owner. You might only own a tiny fraction of the company, but you are still an owner.
As an owner, you want the company to make a profit. You do not just want to know the total profit because that number might be billions of dollars. That number is too big to wrap your head around. You want to know how much profit the company made for every single share that exists.
That is EPS.
Earnings means profit. This is the money left over after paying all the bills.
Per Share means for every single stock ticket held by people like you and me.
If a company has an EPS of five dollars, it means that for every share you hold in your portfolio, the company generated five dollars of pure profit this year.
Now, they might not give you that five dollars directly. We will talk about dividends later. However, that five dollars is legally yours in terms of equity. It stays in the company to help it grow. This usually makes your stock price go up.
Think of it like this. You invest in a lemonade stand.
The stand makes one hundred dollars in profit.
There are ten shares total.
One hundred dollars divided by ten shares equals ten dollars EPS.
That means your one share represents ten dollars of work that the company did. If next year the EPS drops to five dollars, you know something went wrong. If it jumps to twenty dollars, you know business is booming.
How Do You Actually Calculate It?
Okay, I promise I will not bore you with algebra. Seeing how the sausage is made helps you understand what you are buying though.
The basic formula is super simple.
Net Income (Profit) divided by Total Number of Shares equals EPS.
Let us use a real world example, but we will simplify the numbers so our heads do not hurt.
Imagine a company called InvestNest Coffee Co.
Last year, InvestNest Coffee sold a ton of lattes. After paying for the coffee beans, the milk, the rent, the electricity, and the taxes, they had $1,000,000 left over in pure profit.
Now, let us say there are 500,000 shares of InvestNest Coffee floating around the stock market.
To find the EPS, we just do the division.
$1,000,000 profit divided by 500,000 shares equals $2.00.
The EPS is $2.00.
This tells us that every share earned two bucks.
Now imagine a different company called TechBubble Inc.
They also made $1,000,000 in profit. However, TechBubble has issued way more stock. They have 10,000,000 shares out there.
$1,000,000 profit divided by 10,000,000 shares equals $0.10.
The EPS is only 10 cents.
See the difference? Both companies made the exact same amount of money. InvestNest Coffee is arguably a better value for each shareholder because you get a bigger chunk of the profit pie with each share you buy.
This is why you cannot just look at Net Income alone. You have to look at EPS to see how that income is sliced up.
The Two Flavors of EPS called Basic and Diluted
If you look at a financial website like Yahoo Finance or your brokerage app, you might see two different EPS numbers listed. This trips up a lot of new investors so let us clear it up.
You have Basic EPS and Diluted EPS.
Basic EPS is the math we just did. It is profit divided by the shares that exist right now.
Diluted EPS is the “Worst Case Scenario” number.
What does Diluted mean?
Imagine you are drinking a nice strong iced coffee. Then the ice melts. The coffee gets watery. It is diluted.
In the stock market, dilution happens when a company creates new shares. Maybe they pay their employees with stock options. Maybe they issued bonds that can turn into stock later. If all those options turned into real stock tomorrow, there would be more shares in the pool.
If there are more shares, your slice of the pie gets smaller.
Diluted EPS calculates what the earnings would look like if all those potential new shares suddenly existed. It is almost always a slightly lower number than Basic EPS.
Which one should you look at?
Always look at Diluted EPS. It is the more honest number. It tells you the truth about your ownership if everything hits the fan. Conservative investors like us here at InvestNest prefer the honest truth over the rosy picture.
Why Does EPS Move the Stock Price So Much?
Have you ever noticed that sometimes a company reports their earnings, and the stock price shoots up ten percent in five minutes? Or sometimes it crashes twenty percent?
That is the power of EPS.
Wall Street analysts spend all year guessing what a company’s EPS will be. They might say that they think Apple will make $1.50 per share this quarter. This is called the Consensus Estimate.
If Apple reports $1.60, which is higher than expected, investors cheer. The company is more profitable than we thought. The price goes up.
If Apple reports $1.40, which is lower than expected, investors panic. They scream that something is wrong and sell. The price goes down.
It is all about expectations.
For you and me as long term investors who are not trying to day trade, these daily swings do not matter as much. What matters is the trend.
The Trend is Your Friend
I want you to pull up a chart of a company you like. Look at their EPS for the last five years.
Is the EPS going up every year?
Or is it bouncing around randomly?
You want the first one. You want a staircase going up. That shows the company is getting better at making money over time. A jagged and unpredictable line is a red flag. It means the business is unstable.
How to Use EPS to Pick a Winning Stock
Okay, so we know what it is. Now how do we use it to actually make money? Here is a simple checklist I use when I am looking at a new stock for my own portfolio.
1. Check the History
Do not just look at this year’s number. Look at the last three to five years. Is the company growing its earnings? If a company has been around for ten years and their EPS has not moved, they are stagnant. Stagnant companies rarely make for great investments unless they pay huge dividends.
2. Compare it to the Price
This is the next level. You cannot just say high EPS is good. You have to ask how much it costs to buy that EPS.
There is a ratio called the P/E Ratio or Price to Earnings. It is calculated by dividing the Share Price by the EPS.
Let’s say the Stock Price is $100.
The EPS is $5.
The P/E Ratio is 20.
This means you are paying $20 for every $1 of earnings.
If you find a company with a growing EPS but a low P/E ratio compared to its competitors, you might have found a bargain. It is like finding a designer shirt on the clearance rack.
3. Watch Out for One Time Events
Sometimes a company will have a massive EPS one year. It might look huge like fifty dollars when normally it is two dollars.
You dig into the news and realize they sold a factory this year.
That is a one time event. They cannot sell that factory again next year. This is why you have to read the footnotes or at least a good summary. Do not get tricked by a one hit wonder year.
4. What About Negative EPS?
Sometimes you will see a negative number. This means the company lost money.
Is this bad? Usually yes. But for new companies like tech startups, it is common to lose money for a few years while they grow. Amazon lost money for years before it became the giant it is today.
However, if you are looking for a safe and reliable nest egg stock, a negative EPS is usually a sign to stay away until they figure out how to turn a profit.
Real Talk about The Buyback Trick
I want to share a little insider tip with you. There is a cheat code companies use to boost their EPS without actually making more profit.
Remember our formula? Profit divided by Shares equals EPS.
To make the EPS number bigger, the company has two choices.
First, they can make more profit which takes hard work.
Second, they can reduce the number of shares which is just a math trick.
Option two is called a Stock Buyback. The company takes its own cash, goes into the market, and buys its own shares. Then they destroy them.
Now there are fewer shares. Even if profit stays exactly the same, the EPS goes up because the pizza is being cut into fewer slices.
Is this bad? Not necessarily. It means the company believes in itself enough to buy its own stock. It also increases the value of your shares. However, you should be aware of it. If a company’s EPS is going up only because of buybacks and not because they are selling more products, that is a warning sign. It is artificial growth.
Conclusion: It Is Just One Piece of the Puzzle
I know we just spent a lot of time talking about how great EPS is, but I need to leave you with one final thought. Do not rely on just one number.
Investing is like cooking a meal. EPS is the salt. It is essential. You cannot make a good meal without it. However, if you only use salt, your food is going to taste terrible.
You need to look at other things too. You need to look at how much debt the company has. You need to look at who is running the company. You need to check what their competitors are doing.
Understanding EPS is the first big step though. It shifts your mindset from hoping a stock goes up to acting like an owner of a business. You want to see how much profit your business is making.
That mindset shift is what separates the gamblers from the investors.
So the next time you open your investing app, do not just stare at the squiggly green line. Look for that little EPS number. Check the history. Ask yourself if this company is getting better at making money.
If the answer is yes, you might just have a winner for your InvestNest.
