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EPS Roller Coaster

One of the most common ways to measure the health of the stock market is to calculate the earnings per share of the stocks in an index–like, say, the S&P 500.  The mathematics is not hard: you simply divide each company’s after-tax profit divided by the number of shares outstanding.  Theoretically, this tells you how much net profit one share of a company is producing; the higher, the better.

As you can see, this calculation doesn’t tell us whether any particular company is a good investment, because it doesn’t factor in what you would have to pay for a share of its stock.  But we routinely hear that “earnings per share is near record levels,” with the clear implication that the economy is recovering and the investment markets are healthy.

Is this true?  Earnings per share has been trending upward since 1926 which have  become increasingly volatile over time, and recently the bumps have been pretty dramatic.  That means that any predictions you might hear about earnings per share should be taken with a grain of salt–and, maybe, a dose of aspirin as well.  Increasingly volatile share prices, an uncertain economy and other factors make it hard to rely on this measure as an indicator of anything in the future–especially the future returns on your investments.

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