Beware the earnings per share trap. What are the most important indicators you should know before buying any stock?

Don't Rely on Earnings Per Share (EPS) Alone: ​​A Common Mistake That Can Cost You a Lot as an Investor

Many investors make a grave mistake when evaluating company performance by focusing on just one metric: earnings per share (EPS). This metric alone isn't enough to make smart investment decisions. In this article, we'll discuss why you shouldn't rely solely on EPS and what better alternatives are for evaluating company performance.

What is EPS? And why do investors overestimate its importance?

Earnings Per Share (EPS) is a financial indicator used to determine how much profit a company generates per share of outstanding shares. It is calculated by dividing a company's net profit by the number of outstanding shares.

Some investors view this number as the "key to success" and rely on it as the primary, and perhaps sole, metric in their buy or sell decisions. However, this narrow view can backfire and negatively impact their investment decisions.

The Illusion of Apparent Growth: When Numbers Are Misleading

Earnings per share may appear high in a given year, but in reality, they do not reflect any real improvement in performance. For example:

Share buybacks: 

Some companies buy back a portion of their outstanding shares, reducing the number of shares and thus increasing earnings per share, even if actual earnings are declining.

Focusing on short-term profits: 

In order to temporarily improve earnings per share, company management may resort to decisions that are detrimental in the long run, such as reducing necessary operating expenses or cutting investments in research and development.

These strategies may seemingly boost financial indicators, but they weaken the business and reduce the company's ability to compete in the future.

Manipulating the Numbers: Borrowing to Improve the Numbers

A company can increase earnings per share simply by borrowing and using the funds for expansion or share buybacks. While this move may boost short-term numbers, it carries significant risks:

• Higher cost of capital.
• Increased debt and financial risks.
• Lowered confidence in the long term.

Borrowing is a financial tool used by companies to finance their activities and expand their operations. However, when companies resort to excessive borrowing, they may face several negative consequences that affect their financial stability. The most prominent of these negative consequences is the increased cost of capital due to the high interest rates required to pay on loans, which reduces long-term profitability. Excessive borrowing also increases a company's financial risks, especially if economic conditions are unstable or if the market experiences severe fluctuations. In the event of a financial crisis, the company may find itself unable to meet its obligations, which could lead to bankruptcy or liquidation.

Therefore, Islam forbids borrowing with interest, or what is known as usury.

The Impact of External Factors: False Success That Doesn't Reflect Efficiency

Some companies' profits may increase due to factors beyond their control or their operational efficiency. For example:

Rising oil prices may lead to growth in energy companies' profits, without the company having a direct role in this growth.

Lower interest rates may reduce financing costs and positively impact profitability, but they don't necessarily reflect the quality of the company's management or its efficiency.

This type of temporary growth cannot be considered evidence of a company's strength, and investors should be wary of it.

Lack of Capital Employed: An Incomplete View of Efficiency

One of the major weaknesses of EPS is that it doesn't reflect the amount of capital used to achieve these profits. Two companies may achieve the same profit and EPS, but:

The first company used little capital efficiently.

The second company required twice as much capital to achieve the same results.

This is where other metrics, such as return on investment (ROI) or return on equity (ROE), come in. They provide a clearer picture of the efficiency of resource use.

Alternative Metrics to Consider

To comprehensively and professionally evaluate a company's performance, you must consider a comprehensive set of metrics, including:

1. Growth in revenue and profits over multiple years.
2. Operating profitability and gross margin.
3. Debt level and debt-to-equity ratio.
4. Return on investment (ROI) ratio.
5. Free cash flow.

All of these metrics help you build a realistic picture of the company's position and future growth opportunities.

Conclusion: Don't be fooled by EPS alone.

Earnings per share are an important tool, but they are not sufficient on their own to make sound financial decisions. A smart investor must analyze a company's performance from all angles and consider the full context of the numbers.

Blindly focusing on EPS can lead to falling into the trap of companies that "to improve" their results to achieve short-term goals. Successful investing is based on comprehensive analysis and a long-term strategy.