There are many factors which are to be considered, while making direct investment in the stock market. The past and present performance of the company, its business model, future growth, and cash position are some of the important factors to consider. However, any business can survive and grow only if it is making a decent profit; and the earnings per share ratio can help you to determine the profitability of a company.
How to Calculate EPS?
EPS = Net income – Dividends paid/Average outstanding shares
Thus, the basic EPS can be calculated by dividing the outstanding shares of the company at that time from the amount obtained, by subtracting dividend on the stock from the net income of the company. Since the outstanding shares can change, we should take the average number of shares over the reported term for our calculation. The more the EPS, more would be the profitability of the organization. The chances of getting high returns on investment are maximum, if you invest in the stocks of a company having a high EPS value.
Let us assume that a company Y earned a net profit of USD 200 and has twenty shares outstanding. Also assume that a company Z also earned a net profit of USD 200 and has fifty outstanding shares. Then, the ratio for company Y would be 10, i.e., 200/20=10 and that for company Z would be 4, i.e., 200/50=4. So investing in Y, which has a higher ratio as compared to Z, would be the right strategy. Apart from the basic EPS, you should also have the knowledge of trailing, current, and forward EPS for succeeding in your investments. However, there is one more important factor to consider while investing in an organization and it is the Price to Earning (P/E) ratio.
How to Calculate P/E?
It is a ratio of the current market price of the stock and the net profit earned by the company per share. Given below is the formula to calculate the same.
P/E = Market price of the Stock/Earnings per share
If the P/E ratio of the company is high, then we can arrive at a conclusion that investors are paying a higher price for that stock. This does imply that the stock has become expensive and somewhat risky. So, it would be advisable to invest in other companies with low P/E ratio. You can also compare the P/E of a particular company to the average P/E value of all the companies in that particular sector, to decide whether you should buy stocks or not. In short, investing in stocks of companies which are trading at low P/E ratio and have strong fundamentals and balance sheet, along with good history will be profitable.