Guide to using the EPS ratio to select potential company stocks

Why Investors Need to Understand What the EPS Indicator in Stocks Is

When entering the stock market, the first question every investor asks is: “Which stocks are worth buying?” To answer this, you need to understand a fundamental financial indicator: the EPS index (Earnings Per Share - Earnings per Share). This indicator is a tool to evaluate a company’s business performance and helps you forecast future stock price trends.

The EPS reflects the profit-generating ability of each share you own. It is calculated by taking net profit (after preferred dividends) divided by the total number of shares outstanding in the market. The specific formula is:

EPS = (Net profit - Preferred dividends) / Number of shares outstanding

In other words, EPS helps you know how much money the company makes for each of your shares.

How to Better Understand the EPS Indicator?

Let’s look at a specific example: Company B had a net profit of $1,000 in 2020, with 1,000 shares outstanding. The EPS at that time was 1000 ÷ 1000 = $1 per share.

In 2021, the company increased its profit to $1,500, but the number of shares remained (the same 1000 shares). Now, EPS = 1500 ÷ 1000 = $1.5 per share.

The EPS increased by 50% in one year — this is a positive sign indicating the company is growing strongly. Usually, when EPS increases consistently, the market expects the stock price to rise in the long term.

However, there is an important note: Short-term EPS growth (less than 1 year) does not necessarily mean the stock price will increase. Because short-term stock prices are mainly influenced by market sentiment and cash flow, not solely by financial data. When the market is optimistic, money flows into stocks, and prices go up. When the market is pessimistic, investors avoid risky assets, causing a market decline over 6-12 months.

Factors Alongside EPS That Help You Make Better Investment Decisions

Relying solely on EPS is not enough. To select promising stocks, investors need to combine EPS with many other indicators:

Revenue (Revenue) — This indicator shows the company’s total income. The relationship formula is:

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

Typically, revenue growth → net profit after tax growth → EPS increase → stock price rise.

However, beware of a scenario: if the company owns assets like land, factories, offices, then revenue alone is insufficient for judgment. Because a company might sell assets to generate temporary profit, but its core business could be deteriorating. Therefore, deeper analysis is needed to understand where the company makes money from.

Dividend (Dividend) — This is the portion of profit distributed to shareholders. Stable and increasing dividends are good signals, indicating sustainable operations. The market often assesses a company’s financial health based on whether it pays dividends or not. If a company is profitable but does not pay dividends, this needs explanation.

P/E Ratio (Price-to-Earnings Ratio) — This is the ratio between the current stock price and EPS. The formula: P/E = Stock price ÷ EPS

If P/E > 25, the stock is considered (overvalued). If P/E < 12, the stock is considered (undervalued). P/E is like a “payback period” — it tells you how long it takes to recover your initial investment based on current profits.

Share Repurchase Policy (Share Repurchase) — This is a strategy that helps companies increase EPS without increasing profits. How it works: the company buys back some of its outstanding shares, reducing the total number of shares in circulation.

Example: In 2018, company CCC had a profit of $40 and 40 shares outstanding. EPS = 40 ÷ 40 = $1. Stock price was around $40.

In 2019-2020, profits decreased to $20, but the company decided to buy back 20 shares. Now, EPS = 40 ÷ 20 = $2. The stock price could rise to $80 — double.

In this case, total profits remain unchanged, but EPS increases because the number of shares outstanding decreases. This is why investors should pay attention to a company’s share repurchase policy.

Warnings When Using the EPS Indicator

Do not evaluate EPS based on only 1-2 years — EPS reflects the current state of the company but does not reveal how the company makes money. For example, a company might sell assets (land, factories) to generate temporary profit, causing EPS to increase on paper, but its core business could be declining. To make safe investment decisions, you should review EPS over at least 5 years.

EPS growth is not always good — You need to evaluate the company’s (Cash flow). Netflix is a typical example: the company’s EPS has increased continuously over many years, but its cash flow is lacking, and debt is increasing. In other words, the company may report high profits on paper but still have to borrow money to operate. This is a dangerous sign for investors.

Combine multiple indicators to increase success rate — The more indicators and analysis methods you use, the higher your chances of profit. A potential stock selection formula includes:

• High and stable EPS
• Stable business operations
• Stable and increasing dividends
• Low P/E ratio
• Company has a share repurchase policy

Conclusion

The EPS indicator in stocks is a fundamental yet powerful tool to evaluate stock quality. However, it is not the only factor determining your success. Smart investors will combine EPS with revenue, dividends, P/E, cash flow, and other indicators to build a solid portfolio. Remember, stock investing is a marathon, not a sprint, so focusing on companies with stable long-term EPS growth will yield better results.