Earnings per share (EPS) represents a company's net earnings divided by the total number of shares outstanding. EPS changes have the biggest influence on stock prices over the long run -- stock prices increase when company profits grow, and decrease when company profits decline. But in the short term, the relationship between EPS and stock prices is not always straightforward.
Investors use annual EPS to evaluate stocks, but companies report EPS quarterly. A quarterly change in EPS will therefore affect the annual EPS. As the actual EPS change, investors adjust their stock price expectations and valuations.
Most companies have established EPS growth rates and those rates are usually priced into the stock ahead of the actual reported numbers. When a company reports EPS, it can be in line with, below, or above expectations. If the reported amount meets expectations, the EPS change may not affect the stock price much because the stock may have already priced in the expectation. If the reported EPS are substantially more or less than expected, the stock price may follow to adjust for the difference between the expected and actual numbers. The stock price change often depends on how much the reported numbers differ from the expected ones.
If a company reports a 25 percent increase in earnings, when analysts only expected a 15 percent increase, the stock price is likely to move up in trading. However if the company reports a 10 percent EPS increase, which is significantly less than analysts expected, it's like the stock will fall in the price as a result.
EPS Decrease or Loss
If a company reports a decrease in EPS, and its shares fall suit, the stock's price-earnings ratio (P/E) will jump due to lower EPS. Investors will revise downward their future EPS growth and P/E expectations for the company based on lower reported numbers. But if the company reports losses, its P/E will disappear altogether and the stock price will be much less predictable, because it is harder to value a company that is losing money. Since investors won’t be able to use EPS, they can apply other yardsticks such as price-to-sales ratio, or look at the company’s prospects or assets.
- “One Up on Wall Street”; Peter Lynch; 2000
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Based in San Diego, Slav Fedorov started writing for online publications in 2007, specializing in stock trading. He has worked in financial services for more than 20 years, serving as a banker, financial planner and stockbroker. Now working as a professional trader, Fedorov is also the founder of a stock-picking company.