When you get ready to invest in stocks, it helps to know some of the things that make the markets tick. You don't need a PhD in economics to make a wise stock investment, but it helps to know the relationship between such factors as a company's earnings per share and the market price of its stock.
Earnings Per Share
If you want to know how a company is doing financially, look at its bottom line. This means the actual bottom line on a company's income statement. The income statement reflects the company's income for a specific period of time, as well as any expenses and costs incurred to generate that income. Earnings reports of public companies typically are released quarterly. Subtract expenses from revenue and you have the company's earnings, or profit. Divide the earnings by the number of outstanding shares of company stock and you can calculate the earnings per share, or EPS. By comparing the quarterly or annual EPS to previous EPS from a prior period, you can track a company's profitability over time.
Market Expectations
Investors sometimes value a company based on expectations, and the market price often fluctuates if the company exceeds or fails to meet those expectations. A company's EPS is one indicator of a company's performance, and the market price of a company's stock can be influenced by its earnings per share. If the company's EPS is higher than anticipated, the market price of its stock will often rise. If its EPS is lower than anticipated, the stock price might fall, even if the company is sound and earned a profit.
Stock Price vs. EPS
While a company's EPS will often influence the market price of its stock, the relationship is rarely inverse. The company's EPS is determined by dividing the earnings by the number of outstanding shares. The market price of each share is immaterial. For example, a company might have 1 million shares of stock outstanding. If that company earns $1 million dollars, its EPS is $1. It doesn't matter if the market price for the stock is $10 per share or $100 per share.
Circular Relationship
Few things in the investment world operate in a vacuum, and stock price and EPS are not exceptions. A company with strong earnings per share might see the market price of its stock rise. This higher stock price might create a positive impression of the company's products in the minds of customers, resulting in greater demand, increased sales and ultimately higher earnings. The inverse might also occur. Poor EPS might depress stock prices resulting in lower consumer confidence, fewer sales and ultimately lower earnings per share. But these relationships are circular and not direct.
