In the last entry we talked about using the P/E ratio to help us determine if the current stock price is overvalued. Let’s now take a look at another measure that lets us see how much of the company’s value will be ours as a shareholder. This is the earnings per share (or EPS).
If we think of the P/E ratio as being the number of positive reviews our prospective purchase has, the EPS tells us how many of the total number of reviews these positive ones represent. Think again about online reviews posted by customers. For any product we might be considering, there are generally three categories it can be in (if we ignore bad products with only negative reviews). First, it might have lots of reviews that are all positive. This is a stock that has a great (i.e., low) P/E ratio. We like those. Second, it might have only positive reviews but they have been posted by few customers. This is a stock with a poor (i.e., high) P/E ratio. We want to avoid those. Third, it might have lots and lots of reviews but they’re mixed. In order to make our decision we have to decide what fraction of those reviews need to be positive for us to feel comfortable making the purchase. The EPS can help inform our decision.
EPS tells us the portion of a company’s profit allocated to each outstanding share. In other words, how much money does the company make compared to how many shares are out there. This is like asking “how many of the reviews are positive?” If the EPS of company A are higher than those of company B, company A generates more money per share, and, as a shareholder, you own part of that income. Experts will say that EPS is the single most important factor in determining a share’s price, but as buyers of blue chip companies on the S&P 100 we needn’t be very concerned about it. It’s more important to institutional investors and speculators who might be making decisions to own a stock for the short term. That’s not us. As with the other 4 factors, I assign a score to each company on the S&P 100 but, admittedly, I put less weight on EPS than the others. These established companies are long-lived because they’ve shown the ability to be profitable. EPS serves as a good tie-breaker if I need it.
That’s it. That’s how I choose a stock. By considering these five factors, each stock earns a score and, often, the stock with the highest score wins. That’s the one I buy. In the next post we’ll look at the scoring system I use and practice applying it using an example.