Earnings per Share Analysis: High EPS vs Low EPS
Earnings per Share EPS is one of the most used ratio to value the Stocks. But the ratio is not an objective measure, it reflects the subjective expectations of the Mr. Market.
In this Post, we compare High EPS vs Low EPS for investors and Traders under the assumption that the other financial ratios and metrics remain the same. And we we consider an eps to be high if it is above the benchmark index’s eps and low eps vice versa.
High Expectations: in case of any dissapointment, Mr. Market would severly punish the Stock with an overreaction. And if the dissapoitment is not temporary the investors will experience a high lost and the recovery from it would take a long time.
High Volatility: Stocks with Mr. Market’s high expectations are more subject to speculations and psychological mood swings of the market.
Expensive? Not necessarily, a stock’s price can rise for decades despite the high eps and your acquisition cost can be a bargain after couple of years. There are some cheap or under valued stocks with high eps.
Low Expectations: Mr. Market has no hope about the growth prospects of the Company. But Mr. Market is very short term oriented. In long term, the stock can be a star of the market which heavily depends on the CEO. Has he patience and long term goals?
Low Volatility: Usually, the stocks with low eps have low volatility unless the reason for low eps is that the company is in a trouble. In the later case, the stock can be very volatile.
Cheap? Not neccessarly, “cheap” stocks can always become “cheaper”. Never and never think that a stock became cheap just because the price is declined.
When is a stock with high EPS overvalued?
Earning per share is calculated by dividing of the Share Price by Earnings per Share or Market Capitalization by Company’s Net Income. Only the earnings power of the company can return the invested capital: either as dividends or as growth in the company’s value which depends on the estimated future dividends. Therefore, the ratio between Market Capitalization and Net Income is crucial for a long term investor who risks his investment capital on a stock and can use only the fundamental analysis.
If a stock has a higher EPS than a benchmark index there could be three main reasons:
The company pays higher dividens than index. If a company has high profit margins because of its wide economic moat but low growth prospects then the management can either buy back shares which will increase the future dividends or pay high dividends to return the profits to shareholders. Thanks to high profit margins, the company can pay higher dividends than index and the dividend payment can be more stable and secure. For example Coca Cola (KO).
Some companies operate in highly capital intensive businesses (telecom, refineries, oil & gas pipelines etc.) but they can finance it in bond markets with relative low interest rates, lower than capital amortization costs. Usually, those companies have high operating cash flow which can ensure the steady payments of dividends. For example TransCanada Corp. (TRP).
The problem with dividend companies is that their investors are expecting dividends even if the company makes losses. Otherwise, those companies would harshly punished by markets because they will lose the status of being a dividend company. And sometimes, they make losses which makes dividend payment diffucult. In this case, either they make more debt or they decrease their capital expenditurs – which means they liqudate themselves!.
High dividend payments can lower the volatility of the stock price even if the stock has high EPS. And in times of low interest rates, the company can buy own shares after issuing bonds. In this case, Earnings per shares will rise which will drive the share price higher and enable higher dividend payments but the balance sheet will also weaken because Net Income of the Company will remain the same, unless the Company’s business can grow enough . Buying own shares via more debt to pay more dividend can force the company to cut dividends and to dilute shares when business encounters some troubles.
The dividend companies have also to grow to protect the real value of invested capital and at least to provide the same growth of the benchmark index. Otherwise why should we prefer them over index ETFs or Funds.
In short, to determine wheter the EPS of a dividend stock is higher or not, a dividend investors should consider:
(1) the dividend yield of the benchmark index and the future interest rates
(2) at least moderate growth potential
(3) strong balance sheet
(4) the trend of operating cash flow and capital expenditures
next Growth Companies, coming soon….
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