EPS - impact, meaning, how to increase it, link with the P/E ratio
Hello,
I am preparing for interviews in IB and I want to understand concepts deeply. I have difficulties with EPS related concepts.
Could you please explain to me :
1) Why EPS ( basic + adjusted with dilutive securities) is so important?
2) Therefore, why a company would issue common stock or stock option if that results in a decrease of EPS?
3) What is the link between EPS and P/E?
Thank you for your help !
Feel free to let me know if the question has already been discussed!
> 1) Why EPS ( basic + adjusted with dilutive securities) is so important?
EPS at its very core represents the amount of net income attributed to one share, and is a measure of profitability. However, more importantly, it takes the number of shares into account, which is very important to consider in a post-acquisition situation where shares have been issued to finance the purchase.
> 2) Therefore, why a company would issue common stock or stock option if that results in a decrease of EPS?
A company would issue shares even if it means a decline in EPS (assuming net income remains constant) if it is more advantageous to issue equity than take on debt to raise funds, either due to debt/stock market limitations or if share price was lower than the perceived fair value of the company. No fixed reason for this, it really depends on the situation.
> 3) What is the link between EPS and P/E?
You can do a Google search for this, come on...
Thanks a lot for your response ! :)
Yes aha, my last question was not clear, I know that P/E Ratio = current stock price / earning per share (EPS), But fail to understand the concept behind P/E ratio, what it meant ...
Maybe think about it in terms of Equity Value / Net Income, which is the same things as Price per share / Earnings per share
1) EPS is all about showing how much you earn per share you own. It's a way to say that if I own a share of stock, it's how much I am getting in terms of growth of my owner's equity. This way, I can see that, after all is said and done, my shares produce X dollars of growth per share I own. Mind you, this doesn't factor in things like invested capital, which can be used to compare efficiency - a company that uses less capital and produces the same EPS as another can be seen as more efficient. People like EPS because it's an easy way to compare companies within the same industry on a level playing field.
As far as Basic and Diluted are concerned, Basic is your prima facia view of EPS. Based on what's outstanding and available, we have a clear picture of how much earnings is available to the public. Diluted factors in every share that can be outstanding (Stock Awards that are executable, Warrants, Converts, etc.), to give a picture of how the company's EPS is when you take into account every possible ownership situation.
2) What's cheaper - equity or debt? Companies fund themselves based on what's cheaper. If I issue 3 year bond for $100 in principle at 6%, I will eventually need to pay back a total of $118 to bondholders at the end of those 3 years. And if the company goes bankrupt, those bond holders can still recover in bankruptcy. If I issue equity, I don't have to guarantee any returns because the upside is growth as a result of ownership, and if the company goes bankrupt, then I'm out the cost for buying the stock. Additionally, stock issuance doesn't necessarily result in a decline in EPS. There are lots of factors that go into that one based on what drives earnings.
3) The link between EPS and Price to Earnings should be pretty clear. EPS is the denominator of the P/E Ratio.
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