Calculate earnings per share in conjunction with other financial ratios, like price-sales, and you’ll add to the depth of your stock researching capabilities

One key fact about life in today’s investment world is that it offers a multitude of choices. I mentioned a few weeks ago that when we feel a particular industry segment or business tactic works against investor interests, we don’t make a “best of a bad bunch” selection. Instead we just stay out of investments whose business plan seems to work against investor interests.

At the same time, we all exist in a constant state of information glut. Even experienced business people and successful investors often have gaps in their knowledge of minor investment issues. This is why it is important to understand how to look at stock specifics more closely, including the ability to calculate earnings per share.

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Calculate earnings per share to understand a stock more deeply

To calculate earnings per share (EPS), you divide total earnings by the number of shares outstanding.

If total earnings are unchanged and the number of shares outstanding rises, then EPS goes down. However, if total earnings AND the number of shares outstanding both go up, but total earnings rise faster than the number of shares outstanding, then EPS still goes up. It just rises at a slower rate than total earnings.

In the course of a year, companies often raise the number of shares they have outstanding. They may sell or issue new shares for various reasons: to make acquisitions, settle debts, or as part of employee compensation, for example. This expansion in total shares outstanding cuts the growth rate in EPS, compared to the rate of growth in total earnings.

Something like this happens in reverse when a company buys back its own shares. This cuts the number of shares outstanding. As a result, total earnings are divided by a smaller number of shares outstanding. So, per-share earnings rise by a bigger percentage than total earnings.

If you calculate earnings per share alongside the price-sales ratio, you will add another tool to your stock research

Before you invest in a company, you need to know its financial history, how they allocate funds, and you want to have some idea of what kind of return you can expect for your investment.

One way to do this is by looking at the price-sales ratio. The price-to-sales ratio (P/S) is one measure used to determine the value of a company’s stock. You can use this ratio as a comparison against other, similar companies, to estimate how well a company is performing.

It will give you an idea of how healthy a company is. Likewise, the price-to-sales ratio can also give you some insight into how you may be able to benefit from a particular stock.

Like most of these measures, the price-sales ratio should not be used exclusively to determine the value of a stock. Smart investors will use the price-to-sales ratio as one of many tools to evaluate a potential investment.

The basic rule is that a lower price-to-sales ratio means that a stock is cheap. A higher price-to-sales ratio tends to indicate that a stock is expensive. Still, many individual stocks seem to run counter to this rule. Stocks with deservedly high price-to-sales ratios can rise for lengthy periods, and stocks with deservedly low price-sales ratios can fall.

That’s why it’s important to keep price-to-sales ratios in perspective. They tend to provide hints rather than clear answers. They are only one among many tools in your stock research.

On the other hand, you might uncover a company with an extraordinarily low price-to-sales ratio, such as .01 (for example, a $1 stock with $100 a share in sales). That can indicate a lot of capital-gains potential, if the company can improve its profit margin.

However, a low price-sales ratio is only an advantage if a company can make money on its sales. If the company can’t make a profit, its low price-to-sales ratio may signal danger, rather than a bargain. The low p/s may reflect the fact that well-informed investors are selling the stock (and driving down the price). Money-losing companies eventually go out of business, and that is not where you want to invest your money.

The price-to-sales ratio and earnings per share are just two of the multitudes of numbers that standard analytical techniques generate from the analysis of a single investment. Both are important, but each one has its place.

One key point is that no single number or group of numbers tells you everything you need to know. Successful investors try to detect patterns in the numbers that reveal which things are working in their favour, and which are working against them.

Utilize our Successful Investor approach for a stronger portfolio:

• Hold mostly high-quality, dividend-paying stocks.
• Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
• Downplay or stay out of stocks in the broker/media limelight.

As your investment knowledge grows from novice to expert, you’ll notice more and more details like this. We try to write in such a way that our meaning is clear to all investors, from newcomers to veterans. We welcome feedback that helps us with that goal.

What tools do you use in your stock market research?

What is the biggest mistake you’ve made in your stock market research?