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Using Earnings Per Share to Buy a Stock.

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long road to financial freedom When deciding which stock to buy, what measure do you use? How to you decide that a share is cheap or expensive?

For that, you will have to look at the predictability of the company's earnings record.  Company A has consistently earned returns and it has been increasing at a steady pace. Company B has fluctuating returns albeit with bigger positive returns in certain years but with losses in some years.

 

Year Company A Company B
2005 $0.50 $0.75
2006 $0.55 ($0.20)
2007 $0.65 $0.67
2008 $0.72 ($0.25)

As you look forward and try to predict the future earnings for the next year till 5 years later, which company will you be more confident of predicting?

So the next time you see a company like A, you will be interested to dig deeper to see if the company is worth investing into as you will be able to predict the initial rate of return that you can get.

Assume that in the year 2008, you find that company A is worth investing into after detailed research. At the point that you were interesting in buying into company A, the price was $9.50.  Thus, the initial rate of returns will be 7.6% (0.72/9.50=7.6% rounded to 1 decimal place).

What if the price of company A was suddenly down, as negative news affected sentiment in the industry it was in and the price of its stock became $9.00? At this price point, the initial rate of returns becomes 8% (0.72/9.00=8%). And imagine if you can extrapolate this 8% and more growth into the next few years.

Thus, for us as investors, the key crucial point become whether EPS of the company has a predictable pattern which you can confidently predict for at least 5 years ahead. Then the next point will be at what price you buy into the company at.

If you are interested to know more, you can read Mary Buffett and David Clark's book, Buffettology, which gives a very clear methodology to how Warren Buffett goes about looking at companies and analyses them.

Therefore, there is a very calculative methodology to why Warren Buffett is buying into companies when there is a recession going on. His initial rate of returns becomes high when the companies he buys into has consistent positive EPS despite depressed prices.

He just bought into another company, Becton Dickinson. Do yourself a favor and look into it if you have spare cash for investment.

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