USING EARNINGS PER SHARE EFFECTIVELY IN A RECUPERATING MARKET

A lot has been said about Earnings Per Share (EPS) but there is still more to be discussed. I have met a number of investors with total misconception of what E.P.S is and what it is not. This write-up is aimed at correcting the “absolute confidence” placed in it by some investors. No doubt, the use of EPS is one of the most reliable methods of picking good stocks but it is definitely not all-self-sufficient as misconstructed by some.

What is EPS?

Earnings Per Share is the net profit declared by a company per unit of its shares. This is calculated by dividing the total net profit by the number of shares in issue. If for instance the net profit of a company is N100, 000,000 and the number of shares in issue is 500,000,000 units, then the EPS is arrived at by saying N100m/500m units of shares which is equal to 0.2 or 20k.

How it is used

How is EPS applied in making investment decisions? As earlier said, EPS is the profit per unit of shares of a company. It shows how much a company has to share as dividend or plough back into the business to yield future returns. Therefore, given two identical stocks {selling at the same market price} whether in the same industry or in different industries, the simplest yardstick to use in checking which one is better is by subjecting them to the litmus test of EPS. A good example: stock “A” is priced at N10 in the stock market and stock “B” is also priced at the same N10 per unit. The EPS of stock “A” is 20k and that of “B” is 45k. Looking at it on the surface, a naïve investor will quickly jump to the conclusion that stock “B” is better. Why? Because it records a higher EPS compared to “A” and by implication it means stock “B” will have more money to pay as dividend and also have money to plough back into the business.

Its limitation

But the question is: Does it always work like that? Have you ever wondered why a stock with a lower EPS commands a higher price compared to the one with higher EPS? Has it ever occurred to you why investors will prefer to pay at premium for a stock which EPS is little or nothing to be compared with a counterpart stock? If your mind has been working as mine, you will realize that EPS in itself is not an all-sufficient factor that should influence your investment decision; hence its limitation.

Additional factors to consider

The following are additional factors an investor must consider to complement his buy decision having spotted a stock with strong EPS:

Investors Confidence

We have seen so many stocks whose EPS are high and yet are selling below those with lower EPS. Yes, some may argue that the market is yet to discover such a stock or such a stock definitely has potential for future growth. These are all possibilities, but more often than not, the fortune of such a stock is determined by the level of confidence placed on it by investors. We have myriads of examples at present in the stock market especially at this recovery juncture. If the market does not have confidence in the stock, definitely it cannot do well in the market.

Easy Entry and Exit

The attractiveness of any stock lies in the fact that there is easy entry and exit in and out of such a stock. Irrespective of how robust the EPS of a company is, if the market perception is that it may be difficult to exit as at when desired, such stock may not do well as expected.

Quality of Management/Ownership structure

The integrity, aptitude and industry knowledge of the management paraded by a company is a very important factor to consider. The ownership structure of a company is also very essential. A friend once called me and said he had just spotted an insurance stock with a very strong EPS. Upon a closer look and some findings, I discovered that it will not be a good buy because the company was being run like a “one-man-show”. Of course, he bought the stock but not able to get the desired result because the market did not respond to it.

Consistency/Future prospect

How consistent a company can replicate its past performance is also a very serious issue to consider. A stock could record an exceptional brilliant performance for a season, but that may be short-lived for several reasons. Also, the future prospect of such a company is of great importance.

Source of profit declared

It is not enough to buy a stock based on high EPS which is as a result of huge profit declared. The profit recorded could be from a source outside the regular business of the company e.g. sale of assets like building, machinery e.t.c. when such items are disposed, some organizations capture it as part of income for the accounting year, thereby impacting positively on the profit and by extension the EPS.

The above factors are of course not exhaustive as there are other factors like: Industry regulation, cash Liquidity e.t.c. EPS is a dependable way of identifying and picking a good stock, but it must be supported by other factors to make an informed buy decision.

HOW YOU CAN INVEST NOWAS THE YEAR WINDS DOWN

On the strength of what market performance is now with the influx of third quarter results to the market and stocks are beginning to make significant gains as investors pick up stocks at rock bottom prices which demonstrate that a bullish run appears to be in sight. Therefore the best time to buy is now as the year winds down. Also as a result of the prolonged bearish period in 2008, we have single digit P/E’s and price to book ratios below 1. I recommend the following strategy.

– Invest with the medium term in view. This is predicated on market volatility which makes geometric increase in the prices of stocks slim at this period. On few stocks, 20% gain could be achieved but substantially, you get less before a downward movement in the short term. Investing for medium term towards the first quarter of 2009 is recommended.

– Invest in fundamentally strong stocks that had experienced sharp decline in price in recent time. Consider those with strong last quarter earnings, bright/impressive earnings projection, good product mix and good management among others. Using earnings per share as a sure guide on these stocks.

– Invest in stocks with closer dates of release of the next result. Some results that were expected in December that may not come would be released in January. Target these stocks particularly, when the earning per share outlook is bright.

– Consider some stocks whose calendar year ends in December, their full results will hit the market between first and second quarter 2009.

– Investing profitably for the medium term requires good industries. Attractive industries to consider first include Banking, insurance, Petroleum, Healthcare and few stocks in Conglomerate, Chemical and Paints etc.

You may need specific guide and further investment tutelage against the unforeseen volatility, you can me reach for advisory services.