Understand the EPS Ratio - The Key to Selecting Promising Stocks

What Is EPS Ratio? Why Investors Need to Pay Attention?

EPS (Earnings Per Share - Profit Per Share) is a tool for assessing a company’s financial health. Its essence is simple: it indicates how much profit each share brings to the owner.

The formula to calculate EPS is not complicated:

EPS = (Net Income - Preferred Dividends) / Total Outstanding Shares

In other words, it is the ratio between the company’s after-tax profit and the number of shares issued in the market. Through this indicator, you can quickly evaluate a company’s profitability potential and consider whether the stock is worth investing in.

From Theory to Practice: How EPS Works

To better understand what EPS is and how it reflects actual business performance, let’s examine a specific scenario.

In 2020, Company A reported a net profit of $1,000 with 1,000 shares outstanding. The EPS at that time was: 1,000 ÷ 1,000 = $1 per share.

In 2021, Company A achieved a net profit of $1,500 while the number of shares remained the same at 1,000. Now, EPS increased to: 1,500 ÷ 1,000 = $1.5 per share, a 50% increase.

What does this increase reflect? It shows that Company A’s business activities are growing strongly, and profitability is increasing. In the long term, the market generally expects the stock price to rise accordingly. However, it’s important to remember that in the short term (less than 1 year), high EPS does not necessarily correspond to a high stock price. The reason lies in market sentiment volatility.

When the economy is optimistic, capital flows are abundant, and investors are willing to accept risks to find profit opportunities, making the stock market more active. Conversely, during pessimistic periods, investor confidence wanes, and cautious sentiment spreads, causing stock prices to fall sharply. This market psychology cycle typically lasts from 6 months to 1 year.

Revenue, Profit, and EPS: An Unavoidable Relationship

To analyze EPS accurately, you cannot ignore revenue (Revenue). Revenue is the origin of all figures; it is the first indicator reflecting a company’s business strength.

This relationship follows a logical chain:

Revenue increase → After-tax profit increase → EPS increase → Stock price increase

The calculation of net profit is quite basic:

Net profit = Total revenue - Total operating expenses - Corporate income tax

Generally, companies with higher revenue will have higher profits, leading to higher EPS and stock prices. This is true in most cases.

However, there is a point to watch out for: some companies may own assets outside their core business—such as real estate, factories, or land—that can generate income but are not directly related to core business capacity. To distinguish income generated from actual operations, focus on reported official revenue, as it most accurately reflects the company’s earning ability.

Dividends - A Signal from Management

Dividends are the portion of profits that a company distributes to shareholders. For investors, dividends are not only an additional income source but also a strong signal from the company’s leadership.

When a business performs well and profits are abundant, it often pays dividends to shareholders. This action is viewed by the market as a sign of confidence and financial stability. Conversely, if a company cuts or suddenly stops paying dividends, it could be a warning sign.

The dividend payout ratio depends on each company’s development strategy. But a noteworthy point is that companies with a stable and increasing dividend history over many years are often reliable candidates for investors. McDonald’s is a typical example—this company has maintained a continuous dividend increase for 43 years, alongside steady revenue growth.

P/E Ratio: A Tool to Assess Whether Stocks Are Overpriced or Cheap

The P/E (Price-to-Earnings) ratio is an additional indicator to evaluate stock value. Its formula is straightforward:

P/E Ratio = Current Stock Price ÷ EPS (Earnings Per Share)

A high P/E means the stock price is valued high relative to its earnings. This could be due to investors expecting high growth in the future or might indicate a valuation bubble. Conversely, a low P/E may suggest the stock is undervalued, presenting opportunities for savvy investors.

Typically:

• P/E > 25 is considered high
• P/E < 12 is considered low

However, these standards are not rigid. Each industry has its own characteristics—P/E suitable for a tech company may differ significantly from that of an oil company. Therefore, compare a stock’s P/E with its industry peers for a fair assessment.

For investors, the P/E ratio is like a “time measure”—it indicates how long it would take to recoup your investment if the company’s profits remain at current levels.

Stock Buybacks: A Strategy to Increase EPS

An interesting aspect of stock management is the share repurchase (Share Repurchase) policy. This is when a company uses cash to buy back its issued shares, thereby reducing the number of shares outstanding.

Why do companies do this? The main reason is to artificially boost EPS. When the number of shares decreases but profits stay the same, EPS rises. For example, consider Company AAA:

2018: Net profit of $40, with 40 shares outstanding → EPS = 40 ÷ 40 = $1 per share, stock price around $40.

2019-2020: Net profit remains at $40, but the company repurchases 20 shares, reducing total shares to 20 → EPS = 40 ÷ 20 = $2 per share. With doubled EPS, the stock price could rise to $80.

From an investor’s perspective holding the stock, this is an opportunity to adjust your portfolio or take profits as the price increases. Overall, companies that buy back shares tend to have better stock performance than those that do not.

Golden Rules for Choosing Potential Stocks

When looking for potential stocks based on EPS, consider combining multiple criteria. The more analysis rules you apply, the higher your chances of achieving profitable outcomes.

Key criteria include:

• High EPS: Indicates efficient profit generation
• Stable business operations: Revenue and profit are not highly volatile
• Stable and increasing dividends: Reflects management confidence
• Low P/E compared to industry: Reasonable stock valuation, not overvalued
• Company with share repurchase policy: Shows commitment to enhancing stock value

When all these factors align, you have found a promising candidate for a long-term investment portfolio.

Important Warnings: High EPS Does Not Always Mean Real Profit

Although EPS is a powerful tool, it does not always tell the full story. Two issues to watch out for:

First, do not evaluate EPS over a short period (1-2 years).

An increasing EPS does not necessarily mean the company is genuinely earning money. A typical example: a company sells assets like land, factories, or offices to offset losses from core operations. When looking at EPS, it may appear to increase, but is this company worth long-term investment? Clearly not. For this reason, review EPS over multiple years and observe actual trends.

Second, rising EPS does not mean strong cash flow.

Netflix is a real-world example. Its EPS has increased continuously over many years, creating an impressive appearance. However, Netflix faces a major problem: severe cash flow shortages. The company’s debt is increasing, and cash reserves are depleting. In this case, high EPS is just an illusion if not supported by strong cash flow.

The lesson here is: always check the cash flow (Cash Flow) when evaluating a company, because cash flow truly reflects financial health, while EPS can be “beautified” by various accounting techniques.

With this knowledge, you now have a solid foundation to analyze EPS and make smarter investment decisions for the future.