What does Earnings Per Share(EPS) tell us about the Company?

Introduction:

Imagine you want to buy a company’s shares. One of the most common ways to check if the stock is “cheap” or “expensive” is to look at the Price-to-Earnings (PE) ratio.

The PE ratio is simply the price you pay for a share divided by the company’s earnings per share (EPS)Ref.

If the PE ratio is high, the stock might be overpriced and vice versa.

How Earnings Growth Can Lead to PE Contraction?

If a company’s earnings grow fast, but its share price doesn’t rise as quickly, the PE ratio can actually go down. This is called “PE contraction.”

Explanation:

• PE Ratio = Share Price ÷ Earnings per Share (EPS)
• If earnings (EPS) go up and the share price stays the same or rises slowly, the PE ratio shrinks.
• Investors might not want to pay more for the stock, or they might be cautious about future growth, so the price doesn’t keep up with earnings.

Examples:

Indian Market Example: HDFC Bank
Suppose HDFC Bank’s share price is ₹1,500 and its EPS is ₹100. So, the PE ratio is 15.
In the coming year

1. HDFC Bank’s earnings grow by 20%, so EPS becomes ₹120
2. Due to market worries about the banking sector, the share price only moves up to ₹1,620 (an 8% increase)

The PE ratio in this case will be ₹1,620 ÷ ₹120 = 13.5.

The PE has contracted because earnings grew faster than the share price.

US Market Example: Apple
Suppose Apple’s share price is $150 and its EPS is $5, so the PE ratio is 30.
In the coming year

1. Apple’s earnings grow by 25%, so EPS becomes $6.25
2. The share price only goes up to $162.50 (an 8.3% increase)

The PE ratio in this case will be $162.50 ÷ $6.25 = 26.

Even in this case, the PE has contracted because earnings grew faster than the share price.

What Does a Reduced PE Mean for Investors?

• Stock May Be Undervalued: A lower PE could mean the stock is now cheaper compared to its earnings. Investors might see this as a buying opportunity if the company is still strong(Ref).
• Check the Sector: Sometimes, if a whole sector is out of favour, all stocks in that sector might have lower PEs. Investors should check if the problem is just with the company or if it’s a sector-wide issue.
• Future Growth: If earnings are growing but the market is not rewarding the stock with a higher price, it could mean investors are worried about future growth or there are other risks(Ref)
• Use Other Metrics: Do not rely only on PE. Look at other things like company management, debt, and how the company compares to its peers1.

Key Takeaway For Investors:

When earnings grow but share prices don’t keep up, the PE ratio contracts.

This can make a stock look cheaper.

Investors should check if the company and sector are still healthy before deciding to invest.

Always look at more than just the PE ratio for a full picture(Ref).

References:

1. https://www.miraeassetmf.co.in/knowledge-center/what-is-pe-ratio
2. https://www.investopedia.com/terms/p/price-earningsratio.asp
3. https://www.investopedia.com/terms/p/pegratio.asp
4. https://groww.in/p/pe-ratio
5. https://pages.stern.nyu.edu/~adamodar/New_Home_Page/invfables/peratio.htm
6. https://www.bajajfinserv.in/peg-ratio
7. https://cleartax.in/s/price-earnings-ratio
8. https://corporatefinanceinstitute.com/resources/valuation/price-earnings-ratio/