Earnings per share

Financial ratios - EPS

One of the problems with investing in shares is that we can't predict the future. We can never know for sure how the price will move. Even the great investor, Warren Buffett, is limited by his lack of psychic ability. Of course this is an obvious statement. I do not believe that anyone has supernatural powers with which to predict the future. However, investments do involve an element of analysis and as a result involves assumptions and then ultimately, predictions.

I have often wondered how investors decide how the share price of their current investments will move. After much digging I have come up with one possible solution.

Earnings per share measures the amount of profit before tax divided by the number of outstanding shares in issue. It is supposed to measure how much profit is attributed to each share, i.e what future profits are attributed to that share that you hold. The share price attributes a portion of value to each share. In theory, if you could predict the growth in earnings per share then you would have a decent indicator of how the future share price should move.

But how can we predict earnings per share?

Admittedly there is no easy answer to this question. However, I have been trialing one method. I will use Debenhams Plc as my example. Reviewing the 2012 Annual Report, I found that Earnings per share (EPS) in 2011 was 9.1 pence. In 2012 it was 9.7 pence. This represents a 7% growth in EPS over 2012. Reviewing the past 5 years showed that EPS had grown on average about 6% per annum. Assuming all other variables remain constant, we would expect this performance to continue into the future. As such the value of the shares should also rise accordingly.

So we are using Earnings Per Share growth as a proxy for share price growth.  As a result predictions can be made about future share price movements.  These growth predictions should then be discounted to today's prices (watch out for an upcoming post on the subject of discounting). Essentially, you want to account for the fact that there is inflation eroding the future value of shares.

A Qualifier...or two on earnings per share

There are of course lots of flaws with this method of modelling share price movement. One of the main assumptions made was that all other variables should remain the same. There is nothing to say that this should be the case. It is possible that revenues suddenly drop (e.g. Due to the snow less people may be out shopping at Debenhams), impacting Earnings Per Share. As such, Earnings Per Share do not have to be stable and growing into the future.

Furthermore, there is nothing to suggest that the share price should follow Earnings Per Share growth. Prices have been affected by the "animal spirits" of investors since the first investments were made; over-confidence and over-despair has always been a driver for the movement of share prices. However, in the long run I think it is fair to assume that the Earnings Per Share should be a long term drive of the share price as the price move to reflect the growing value of each share.

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