Earnings per share, or EPS, are a company’s net annual earnings divided by the number of shares outstanding. The stocks of companies that grow earnings faster than the rest tend to go up the most. Stock prices usually parallel EPS growth in the long term, but the link between EPS increases and stock price is not always linear or straightforward in the short term.
If the earning per share of a publicly held company increase, it is typically expected that the stock price itself will increase in turn. However, this behavioral relationship is best witnessed over the long-term due to the fact that short-term volatility could skew trends.
Rate of Growth
The faster a company grows its earnings, the faster its stock price increases, and the higher it can go. For example: If company A grows earnings 15 percent annually, its earnings will double in five years; if company B grows earnings 30 percent annually, its earnings will double in three years. Investors can expect the prices of stocks A and B to increase in line with earnings.
Changes in the EPS growth rate may influence stock prices more than the actual rate of growth. Acceleration in EPS growth will usually result in a stock price increase. For example: If company A, which has grown earnings 15 percent annually, suddenly reports a 20 and then a 25 percent increase in EPS, its stock price could shoot up 25 or even 50 percent. Conversely, a deceleration in a company’s EPS growth can result in a stock price drop.
Exploring P/E Expansion
Price-to-earnings, or P/E, ratio is the stock price divided by the EPS. P/E shows how much investors are willing to pay for a dollar of earnings. The rule of thumb is that, in a fully valued stock, the P/E should equal the EPS growth rate. Stock B in our example should have a P/E of 30. But what investors are willing to pay for a dollar of earnings varies with investor sentiment, market conditions and share supply and demand. Since EPS do not change from quarter to quarter, while stock prices fluctuate daily, a P/E expansion means a stock price increase between EPS announcements. If company B’s EPS growth rate remains constant at 30 percent, investors may be willing to pay progressively higher prices for its stock in a good market, so its P/E could expand to 40, 50 and even 60.
Understanding Investor Expectations
Stock prices always look to the future and discount, or price in, expectations. Next quarter EPS are likely to be priced into a stock by the time they are announced. If the announced EPS increase meets expectations, the stock price may not move at all, or may even drop. A drop would be the result of traders “buying the rumor and selling the news,” that is, buying a stock in anticipation of good news and selling it if the news fails to exceed their expectations. If an EPS increase is more than expected, the stock price could jump on the announcement; if an EPS increase is less than expected, the stock price will drop on the “disappointing” results.
Evaluating Earnings Guidance
Investors sometimes focus more on a company’s earnings guidance than current results. EPS always peak at some point, and the higher the numbers get, the harder it is for a company to beat them. A company may report the highest EPS increase in its history, only to see its stock plunge 20 or 30 percent because the guidance suggested an EPS deceleration or decline.