How Earnings Affect Valuation
Earnings affect Valuation of a Company
The more earnings a company generates relative to the number of shares it has outstanding, the more valuable each share is to investors.
Therefore, when evaluating a company, analysts calculate the earnings-per-share, or EPS.
EPS is a metric that divides the earnings available to common shareholders by the number of outstanding shares a company has.
For example, if a company has $100,000 in earnings and 50,000 outstanding shares, then its EPS is $2 per share.
Example of How Earnings Affect Valuation
Analysts also use the price-to-earnings ratio, or P/E ratio, which is the market price of a share divided by the EPS.
For example, if the same company sold each share for $10, then the P/E ratio is 5.0.
Analysts take this number and compare it to other P/E ratios of similar companies, and with the broader market.
In equity valuation, using ratios such as P/E is called a multiples-based approach.