Financial ratios.

Understanding Earnings Per Share (or EPS)

Earnings means profits. Before you buy a share , this is the first figure that you need to check. An increase in earnings every year is a sign that the company in question is prima facie a good candidate for further analysis. Increasing earnings generally leads to a higher stock price. Most of the high earning companies also pay regular dividend to its shareholders. Analyzing Earnings is the first most important step for investors because they give an indication of the company’s expected future dividends and its potential for growth and capital appreciation. The other names by which earnings are called are – Profits , Income etc.. ( But not ‘Revenues’. That’s a totally different term !)

THE BASICS.

Earnings simply are the company’s profit – how much money did it make in any given period.How does a company calculate earnings ? It’s by deducting the ‘cost of sales’ , ‘operating expenses’ and ‘taxes’ from it’s total sales revenues. The term ‘cost of sales’ is nothing but the total amount incurred of raw materials, labour and other expenses incurred in producing a product for sale. The term ‘operating expenses’ means the cost incurred for operating the business such as salary to staff, legal expenses, advertisement etc.. and taxes are those payments made to the government on the income that’s generated.

POSITIVE EARNINGS.

Investors expect established companies like Infosys to declare high earnings. If they report lower earnings for a quarter, the stock price would immediately tumble. New or Young companies, on the other hand, may go for years with negative earnings and still enjoy the favor of the market if investors believe in the future of the company.

Companies are required to declare it’s earnings figures every quarter.

In India, A financial year starts from 1st of April and ends on the subsequent march 31st. So the quarters are as follows-

Quarter 1 -1st April to 30th June. Earnings for the quarter will be declared in July
Quarter 2 – 1st July to 30th Sept. Earnings for the quarter will be declared in Oct.
Quarter 3 – 1st Oct to 31st Dec . Earnings for the quarter will be declared in Jan.
Quarter 4 – 1st Jan to 31st Mar . Earnings for the quarter will be declared in April.

Companies also declare half yearly results clubbing two quarters. Investors, based on the given facts, try to figure out the expected earnings of the company. This expectation of the investors is what is actually reflected in the share price movements. So, in addition to the actual earnings, the expectation of earnings also play an important part in stock prices . Companies that fail to meet the expectations of the investors gets beaten by the market. Earnings (or growth towards positive earnings) tell you how healthy a company is.

EARNINGS PER SHARE.

The basic measurement of earnings is “earnings per share” or EPS. This measurement divides the earnings by the number of outstanding shares. For example, if a company earned Rs 150 Crores in the third quarter and had 75 Crore shares outstanding, the EPS would be Rs 2 (150 / 75).

WHY EPS?

The reason you reduce earnings to a per share basis is to compare it with another company. For example – Two companies A and B has earned a profit of 150 crores each.Which one would you prefer? Both seems to be ok with you. Right? However, if I say that company A has 75 Crore shares outstanding and company B has 100 crore shares outstanding, which one would you prefer? Your answer lies in the EPS figure.

Company A has an EPS of 2 ( 150/75) whereas company B has an EPS of just 1.5 (150/100). So you prefer the company A that pays you more profit per share.

It’s importants to note here that the EPS is helpful in comparing one company to another, assuming they are competing companies of the same category ( large cap or small cap etc..) in the same industry, but it doesn’t tell you whether it’s a good stock to buy or what the market thinks of it.

EARNINGS PERIOD.

As said earlier, companies report earnings every quarter. April-June is Quarter 1 generally termed as ‘Q1’, July –Sept is quarter 2 or ‘Q2’and so forth. Generally , the quarter results come out by the mid of the subsequent quarter. The market always approaches the earnings reporting day with caution.That day can be a time of some volatility, either up or down for particular stocks and/or sectors.

TYPES OF EPS

The numerator and denominator in an EPS equation can change depending on how you define “earnings” and “shares outstanding”.

Let’s try to crack the numerator (Earnings) first.

There are three types of Earnings numbers:

  • Trailing earnings – last year end earnings figure.
  • Current earnings – current year’s number- part actuals,part projections based on the current performance.
  • Forward Earnings – future numbers which are pure estimates.

EPS calculated with the last year end actual earnings figure is called “trailing EPS”. trailing EPS is the actual EPS figure.
When Current earning estimates are used to compute EPS , it’s called the “Current EPS” and when Future earnings figures are used, it’s called “forward EPS”.

Now, Let’s see the denominator part. (ie Shares outstanding)

Shares outstanding can be classified as either Basic or fully diluted

  • Basic EPS is calculated using the number of shares that have been issued and held by investors. These are the shares that are currently in the market and can be traded.
  • Basic Earnings per share (Basic EPS) tells an investor how much of the company’s profit belongs to each share of stock.

The number calculated this way excludes any possible dilution stemming from outstanding dilutive securities, such as options, warrants, convertible bonds, or convertible preferred stock. Diluted EPS reflects the potential dilution from such dilutive securities. The companies that don’t have any dilutive securities, or the companies that report net losses, report only Basic EPS.

In short, EPS computed can be Trailing EPS (Diluted or basic) or Forward EPS (Diluted or basic).

Know it

  • Earnings means Profits. The term should not be confused with ‘Revenues’ which is a totally different term
  • Companies report earnings every quarter i.e April-June (quarter 1 or Q1) Jul-sept (Q2) so on..
  • The stock market approaches each earnings report with caution.
  • Markets will react positively on a company that declares positive earnings growth. The reverse is also true.
  • The basic measurement of earnings is EPS
  • EPS computed can be Trailing EPS (Diluted or basic) or Forward EPS (Diluted or basic).

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Introduction to financial ratios

Financial ratios are used to evaluate a company- Its Financial Strength, Management effectiveness, Efficiency and Profitability.

Ratios look at the fundamental financial aspects of the company. It gives you an idea about –

  • The current financial position of the company
  • where the company ranks among its peers and if it is properly priced by the market as reflected in its stock’s price
  • Overall, it helps you to decide if a particular company is worth getting involved with.

Since, ratios look at companies from the fundamental level; ratio analysis is also called fundamental analysis. Many investors use fundamental analysis alone or in combination with other tools to evaluate stocks for investment purposes. The ultimate goal is to determine the current worth and, more importantly, how the market values the stock.

There are at least 12 financial ratios you should understand to evaluate a company.

This article focuses on the key tools of fundamental analysis and what they tell you. Even if you don’t plan to do in-depth fundamental analysis yourself, it will help you follow stocks more closely if you understand the key ratios and terms.

It is enough that you understand all these ratios, its meaning, components and relevance. Most of the ratios need not be computed since these form part of the financial statements. All these ratios are available in the internet from various financial websites and magazines.

My favorite site for picking up ratios

To get all the non financial and financial datas of Indian companies, my favorite sites are -

1. Moneycontrol.com

2. In.Reuters.com

List of key ratios :

  1. Earnings per share or EPS
  2. Price to Earnings Ratio – P/E
  3. Market capitalization
  4. Price to Sales – P/S
  5. Price to Book – P/B
  6. Dividend Payout Ratio
  7. Dividend Yield
  8. Book value
  9. Return on Equity
  10. Interest coverage ratio
  11. Current and quick ratios
  12. PEG ratio

Till my next post on ratios …

……have a nice time..!!

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