Investment Must-Read: How to Properly Interpret EPS to Avoid Stock Picking Pitfalls?

If you often read financial reports or investment news, you must frequently hear statements like “a company’s earnings per share (EPS) is growing.” But what exactly does this EPS represent? Why do investors pay so much attention to it? Many people have a vague understanding or are even confused by the surface numbers, leading to poor investment decisions. This article will approach from a practical perspective to help you thoroughly understand EPS and how to use it for scientific stock selection.

What is Earnings Per Share (EPS)? Why Investors Must Understand It

The full English name of EPS is Earnings per Share (EPS), which simply means: the profit a company earns, averaged and allocated to each common share.

This indicator directly reflects the company’s profitability. The higher the EPS, the more value each share is creating for you. Looking at Apple’s EPS trend over the past 20 years makes it clear— as the company expands and grows its business, EPS continues to rise, which is a sign of a healthy company.

For investors, EPS is a core metric to evaluate whether a company is worth buying. The simple logic is: if the company’s profit relative to its stock price is higher, it indicates the stock is undervalued and has more investment potential. Investors also often use EPS to compare competitors within the same industry to see who has stronger profitability.

How to Calculate EPS? Three Steps to Understand Financial Data

Step 1: Understand the three components of EPS calculation

• Net Profit: The remaining money after subtracting all expenses from the company’s total revenue. Found at the bottom of the income statement.
• Preferred Dividends: Fixed dividends payable to preferred shareholders, also visible in the income statement.
• Number of Outstanding Common Shares: The total issued common shares minus the company’s own repurchased treasury shares. This data is recorded in the shareholders’ equity section of the financial statements.

Step 2: EPS Calculation Formula

EPS = (Net Profit - Preferred Dividends) ÷ Weighted Average Number of Outstanding Common Shares

In practice, the “profit attributable to common shareholders” in the financial report already deducts preferred dividends, so you can directly divide this figure by the number of common shares for a quicker calculation.

Step 3: Practical Case Demonstration

Taking Bank of America as an example, from its 2022 financial report we find:

• Net Profit: $27.528 billion
• Preferred Dividends: $1.513 billion
• Weighted Average Number of Outstanding Shares: 8.1137 billion shares

Plug into the formula: (27.528 - 1.513) ÷ 8.1137 = $3.21

This number matches the EPS data in the financial report exactly. Most listed companies will directly state EPS in their reports, so investors don’t need to manually calculate every time.

The Relationship Between EPS and Stock Price: Why Sometimes EPS Grows but Stock Price Falls?

Companies with strong EPS usually see their stock prices rise—this is the market’s normal logic. Higher stock prices boost investor confidence, leading to increased sales and profits, which in turn push EPS higher, creating a positive cycle.

However, in reality, this correlation is not absolute. What truly determines stock price movement is whether: EPS meets or exceeds market expectations.

Case study: When Nvidia released its Q4 earnings in February, despite a clear decline in performance, revenue and EPS beat Wall Street analyst expectations. Coupled with management’s optimistic outlook during the conference call, the stock price surged by 14% overnight.

Conversely, even if EPS is growing, if the growth rate is below market expectations, investors may be disappointed, and the stock price could decline. That’s why paying attention to the “expectation gap” is more important than just looking at the numbers.

Derived Metrics from EPS: Price-to-Earnings Ratio and Its Investment Significance

Once you have EPS data, combined with the stock price, you can calculate the Price-to-Earnings Ratio (P/E ratio) = Stock Price ÷ EPS.

This metric indicates: how many times the market is willing to pay for each dollar of earnings. A lower P/E suggests the stock might be cheaper; a higher P/E indicates higher market expectations for future growth.

Comparing P/E ratios among industry peers is very meaningful. For example, if Company A’s stock is $30 and EPS is $1, its P/E is 30. If the industry average P/E is only 10, it suggests A’s stock might be overvalued. But a high P/E can also mean the market expects significant future growth.

A typical example: Nvidia’s recent P/E soared to 135.9 times, despite a decline in EPS. This indicates that a high P/E isn’t necessarily bad; the key is whether such high valuation is supported by future performance.

Can EPS Be Manipulated? The Three Most Common Investor Traps

Trap 1: Stock Buybacks Artificially Boost EPS

A company can increase EPS without increasing profits by repurchasing its own shares. Why? Because the denominator (number of shares outstanding) decreases, so EPS naturally rises under the same profit level.

Many investors see EPS rising year after year and assume the company’s profitability is improving, but a closer look at the share count reveals it’s often due to stock buybacks—“fake growth.” This is why relying solely on EPS figures can be misleading.

Trap 2: Special Items Distort True Profitability

Certain one-time events—such as asset sales, extraordinary gains or losses from acquisitions, or government subsidies—affect current profits. But these events are usually non-recurring and do not reflect the company’s ongoing operational performance.

For example, Yum! Brands (KFC’s parent) was impacted by the Russia-Ukraine conflict, which forced it to exit the Russian market, affecting that year’s EPS. But this was an extraordinary event, not a sign of operational decline. Relying only on surface EPS can lead to incorrect investment conclusions.

Investors need to learn to distinguish between “reporting EPS” and “adjusted EPS” (excluding special items), with the latter better reflecting the company’s sustainable profitability.

Trap 3: EPS Growth Does Not Equal High Stock Return

This is the most common trap. Data from the semiconductor industry illustrates this well:

From 2020 to now, Qualcomm’s EPS has been much higher than Nvidia and AMD. If you only choose stocks based on EPS, Qualcomm should be the best pick. But actual stock returns over three years: Nvidia up 251%, Qualcomm only 69%.

This shows that a single indicator is never enough. Market valuations differ among companies, industry outlooks vary, and management capabilities differ—all of which influence the final investment returns.

Also Pay Attention To: The Difference Between Diluted EPS and Basic EPS

Financial reports often show two EPS figures: Basic EPS and Diluted EPS.

Basic EPS uses the current actual number of shares outstanding, reflecting the company’s current profitability.

Diluted EPS considers a hypothetical scenario: if all securities that could be converted into shares (employee options, convertible bonds, convertible preferred stock, etc.) are exercised, the share count increases. Under this larger denominator, EPS is “diluted.”

Diluted EPS = (Net Profit - Preferred Dividends) ÷ (Shares Outstanding + Dilutive Securities)

For example, Coca-Cola’s report shows that including dilutive securities reduces EPS from $2.43 to $2.19.

Diluted EPS is more valuable as it reflects potential risks—those securities, if converted, will dilute existing shareholders’ equity. Especially for growth companies, which often issue many options and convertible bonds, paying attention to diluted EPS is crucial.

How to Use EPS for Scientific Stock Selection: Methodology Summary

Key Principle 1: Focus on Trends, Not Absolute Values

Single-quarter or annual EPS figures are meaningless. What matters is: Has the company’s EPS been steadily growing over the past 3-5 years?

Consistent growth indicates the company’s profitability is steadily improving, which is a safe investment signal. Conversely, large fluctuations or continuous decline suggest operational problems.

Key Principle 2: Peer Comparison Is More Meaningful

Looking at a single company’s EPS in isolation is pointless. It must be compared horizontally with industry competitors. Higher EPS indicates higher profitability efficiency, earning more in the same market.

Key Principle 3: Combine with P/E Ratio to Judge Valuation

Having EPS alone isn’t enough; you must consider the stock price. The P/E ratio helps determine whether the market has priced the stock reasonably.

Simple logic: if the industry average P/E is 15, and a stock’s P/E is only 10, it might be undervalued; if P/E is 50, unless you believe the company has extraordinary growth potential, the risk is high.

Key Principle 4: Deeply Analyze the Numbers Behind EPS

The final and most critical step: Don’t just look at the numbers—ask why.

• Has the share count changed? Was it due to large buybacks?
• Is profit growth driven by core operations or special items?
• How big is the gap between diluted EPS and basic EPS?

These details help you identify “fake growth” and avoid pitfalls.

Summary: EPS Is a Necessary Condition, Not a Sufficient One

EPS indeed reflects a company’s profitability, but it is far from the whole story. No single indicator can tell you everything about a company.

Before making an investment decision, besides analyzing long-term EPS trends, peer comparisons, and P/E levels, you should also consider: industry outlook, competitive landscape, management team, financial health, and technological innovation.

View EPS as an “entry ticket” for stock selection, not the final answer. Use it to quickly filter potential investment targets, then conduct in-depth fundamental analysis of these candidates. That’s the scientific approach to investing.