5 Principles for Choosing Potential Stocks Using the EPS Metric

What Is EPS and Why Do Investors Need to Know?

When participating in the stock market, the first question investors need to answer is: does this company actually generate profits? That is when the EPS (Earnings Per Share) indicator comes into play.

EPS is a measure of each share’s profitability, indicating how much money the company earns per outstanding share. The calculation is quite simple:

EPS = (Net Income - Preferred Dividends) / Total Outstanding Shares

Alternatively: Net Profit = Total Revenue - Total Expenses - Corporate Income Tax

The EPS indicator is not only used to analyze business performance but also helps investors assess stock price trends and potential profitability of their investments.

How to Read EPS Over Two Business Years

To understand better, consider the case of Company A:

2020: Net profit $1,000 ÷ 1,000 shares = EPS = $1

2021: Net profit $1,500 ÷ 1,000 shares = EPS = $1.5

Although the number of shares remains unchanged, a 50% increase in EPS indicates positive business development and increased profits. The market generally expects the stock price to rise in the long term. However, this does not apply in the short term, when market sentiment can go against the fundamental trend.

The Impact of Market Psychology on EPS

An increase in EPS does not automatically translate into a short-term stock price increase. Short-term (less than 1 year) stock prices are heavily influenced by market psychology factors rather than fundamental data:

• Optimistic market: Capital flows into risky investment channels (real estate, stocks, forex), causing stock prices to rise
• Pessimistic market: Investors avoid risks, capital withdraws from stocks, causing prices to fall

This phenomenon usually lasts 6-12 months. Only when looking beyond 5 years does the EPS truly reflect the stock price trend.

Summary table of impacts:

The Four Principles for Choosing Potential Stocks

Do not rely solely on EPS. To increase success probability, combine multiple indicators:

1. High EPS - Indicates strong profitability
2. Stable business operations - Predictable income, not too volatile
3. Stable and increasing dividend payout ratio - A sign of confidence in future (McDonald’s example: continuous dividend increases for 43 years)
4. Low P/E ratio - Stock price not overly valued
5. Share repurchase policies - Companies confident enough to reinvest in themselves

The Relationship Between Revenue and EPS

Basic rule: Revenue growth → Net profit growth → EPS growth → Stock price increase

Looking at a company’s total revenue helps distinguish actual profit from business operations versus profits from other sources (selling assets, land, factories). Large and continuously increasing revenue signals the company’s ability to create real value.

EPS and Dividends: Signals of Financial Health

Dividends are the portion of profits distributed to shareholders. When a company is profitable and financially healthy, it often pays dividends. The market uses dividend payout decisions as signals of the company’s financial status and future prospects. The payout ratio depends on each company’s policy.

P/E Ratio: A Valuation Tool

The P/E ratio is the stock price divided by EPS:

P/E = Stock Price ÷ EPS

• P/E > 25: Stock is overvalued
• P/E < 12: Stock is undervalued

P/E acts like a “time measure” helping investors estimate how long it will take to recover their investment. However, different industries have different characteristics, so P/E should be considered within the context of the entire sector.

Share Buyback Strategies and Their Impact on EPS

Share buybacks occur when a company repurchases its outstanding shares on the market. This strategy aims to reduce the number of shares outstanding, thereby increasing earnings per share without increasing total profits.

Specific example:

• 2018: Company AAA has profits $40 and 40 shares outstanding → EPS = $1 (price ~$40/share)
• 2019-2020: Buy back 20 shares, profits remain $40 but only 20 shares left → EPS = $2 (price could rise to ~$80/share)

With the same profits, companies that buy back shares often see higher stock prices compared to those that do not. Additionally, this provides a good opportunity for current shareholders to adjust their portfolios or realize gains.

Important Notes When Using EPS

Do Not Rely on EPS for 1-2 Years

EPS only reflects the current financial picture, not how the company makes money. A company might sell assets (land, factories) to cover operating losses, which can inflate EPS but does not make it a good investment.

Increasing EPS Is Not Always Good

Netflix (NFLX) is a clear example: continuous EPS growth but facing cash flow issues - increasing debt, depleting capital. A company can report high profits on paper but lack the cash to operate and pay debts.

Conclusion: When analyzing stocks, consider EPS in a long-term context (5+ years), combined with cash flow, revenue, dividends, and P/E to make informed investment decisions.