How To Manage Personal Finances Book: Chapter 18- Luggage Etiquette and Earnings Per Share
Author’s Note:
I am posting a text version of this entire book on Substack, and video versions on YouTube. Email ken@stltest.net for details on my 5th book’s publishing date in late ’24 or early ’25.
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A heavy-set man with a limp was trying to drag a heavy bag off the baggage carousel.
He started to lose his balance, so I grabbed the suitcase and pulled it off for him.
Now I’m no hero, but it did remind me of something.
There are dozens of ways that financial analysts evaluate stocks. If you watch the media, you may feel bombarded by investment terms- similar to how fast luggage moves on the baggage carousel.
It can feel overwhelming.
It’s important to leave much of the analysis to an investment advisor, a point I’ve made throughout the book.
However, every investor should understand the concept of earnings per share. This concept is the basis for many types of stock valuation. Simply put, firms that consistently generate earnings are seen as more valuable than businesses that aren’t profitable each year.
Earnings per Share: The Play-Doh Analogy
Did you have a Play-Doh machine as a kid?
You put the dough in the toy, turn the handle, and the dough comes out in different shapes on the other end.
That’s like generating company earnings. For our discussion, earnings, net income, and profit mean the same thing. Here’s how the machine works:
The dough you put in is the material and labor costs to make a product or service
Turning the handle means creating the product or service
The dough that comes out is the profit on the sale
Businesses “turn the crank” on the Play-Doh machine every month to produce profits.
Earnings per Share Formula
Earnings per share (EPS) is defined as:
(Net income available to common stock) / (average shares of common stock outstanding)
In other words, how much did the company earn on each share of common stock?
Not all net income may be available for common shareholders. Firms that issue preferred stock may set aside net income to pay a preferred dividend before a common stock dividend (hence the term “preferred” stock).
Let’s assume that Premier Manufacturing earns $5,000,000 and that the average number of common stock shares outstanding is 2,000,000 shares.
EPS is ($5,000,000 / 2,000,000 shares), or $2.50 per share.
If there are more common stock shares outstanding, the earnings per share will be lower. That’s because you’re “spreading” the same amount of profit ($5,000,000) over more shares of stock.
So, is $2.50 a good, bad, or average return?
The answer is found in the earnings yield:
Earnings yield = (Earnings per share) / (market price of common stock per share)
If Premier’s common stock price is $60 per share, the earnings yield is:
($2.50 earnings per share) / ($60 market price), or 4.2% (with rounding).
You want a high earnings yield compared to the average yield for most stocks.
Here’s the challenge of investing when markets are near an all-time high: When the price you pay for a stock is higher, the earnings yield is lower. Essentially, you’re paying a higher amount for each dollar of earnings.
Keep this discussion in mind when you hear the term earnings per share.