Calculating EPS (Earnings Per Share) and P/E Ratios (Price to Earnings) and Why They are Important

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If you are new to the stock market, you may have come across a couple of unfamiliar terms when you were trolling through Yahoo Finance or Google Finance. EPS (Earnings Per Share) and P/E or P/E ratio (Price to Earnings).

These are both extremely easy, and important, concepts to grasp. Let's start with EPS:

The basic way of figuring out EPS is to take a company's net income, subtract any dividends for preferred stock, and divide by the number of average outstanding shares.

Let's make the calculation easy. Let's say that a company has a net income over the year of $100 million dollars. Let's say that there is $5 million paid out in preferred dividends over the course of a year. This would leave us with $95 million dollars.

There are currently 95 million shares outstanding, and this number has been steady throughout the course of the year. So we have $95 million in total net income after preferred dividends, and 95 million shares outstanding. So if we divide $95 million by 95 million shares, then we are left with a figure of $1.00. This would be our EPS for the stock.

Keep in mind that EPS fluctuates depending on total profits, total dividends paid out to preferred shareholders and total shares outstanding.

To make these calculations easy, simply head over to Yahoo Finance and bring up a quote on your favorite stock. Yahoo has a small box listing the EPS for each and every company, and they do all of the work for you. But this will let you know exactly what it means.

EPS is calculated from the last four quarters of earnings.

Next, the P/E ratio:

To know the P/E ratio, you must know the EPS, which is why we explained EPS first.

The P/E ratio, also known as the "Price to Earnings Ratio" or "Price Multiple" or "Earnings Multiple" is quite easy to figure out.

Simply take the current cost of one share and divide by the Earnings Per Share. Let's take an example:

Microsoft is currently trading at $28.26 per share and has EPS of 1.76. So to figure out the Price to Earnings Ratio, you simply divide $28.26 by 1.76, which would give you a figure of 16.08. This is your P/E ratio.

A Price to Earnings ratio can help you to determine undervalued stocks in a certain sector. For instance, if 20 stocks in the same sector are currently trading with a P/E of 15 and another stock is trading with a P/E of 10, the stock with a P/E of 10 may be undervalued and may warrant closer scrutiny.

Price to Earnings ratio is just one possible indicator for finding a good investment. It is certainly not the only indicator that you should use. Growth stocks will have higher, and possibly even negative P/E ratios. This does not necessarily make them poor investments. A growth stock may have a P/E ratio is 100.
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