Investors can use hundreds of metrics to analyze stocks, but none are more widely known than earnings per share (EPS) and the price-to-earnings (P/E) ratio.
These can be highly effective tools for evaluating stocks. But they don't translate very well to companies that own a lot of real estate. Real estate investment trusts, or REITs, obviously fall into this category.
Here's a rundown of how you can use EPS and the P/E ratio to evaluate stocks, why they aren't very effective for REIT analysis, and an introduction to a better way to evaluate a REIT's "earnings."
Earnings per share and the P/E ratio
The traditional way to calculate earnings per share for publicly traded companies is to start with the company's net income. This is how much a company has earned after paying its operating expenses, interest obligations, and applicable corporate taxes.
Then, divide net income by the number of the company's outstanding shares of stock to calculate its earnings on a per-share basis. This is known as a company's earnings per share, or EPS.
For example, if a company earned an after-tax profit of $10 million and it has 5 million outstanding shares, its EPS would be $2.00 per share.
Many companies also calculate diluted earnings per share using things like unexercised options and warrants to determine how many outstanding shares there could potentially be.
You can calculate the price-to-earnings (P/E) ratio by taking a company's current stock price and dividing by its annual earnings per share. This can be very useful for comparing similar companies with each other to help determine which are the best-priced investments.
For example, if a stock trades for $45 and the company earned $3 per share over the past 12 months, its P/E ratio would be 15.
The P/E can theoretically be calculated based on any 12-month period. It's generally either done on a trailing 12-month (TTM) basis or a forward (next 12 months expected) basis. These are called the TTM P/E ratio and the forward P/E ratio, respectively.
Introducing funds from operations (FFO)
Fortunately, there's a better earnings metric to use when it comes to investing in REITs. It's known as funds from operations, or FFO.
You can read our longer discussion of how FFO works, but the general idea is that it adds the depreciation "expense" back in to offer a better picture of how much money a REIT has actually earned and how much it has available to distribute to shareholders.
Let's consider one real-world example. One of my favorite REITs, Realty Income Corporation (NYSE: O), reported a net income of $95.2 million for the second quarter of 2019. However, when you add the depreciation expense back in and make a few other adjustments to calculate FFO, you can see that the company's actual earnings were much higher.
|Depreciation of furniture, fixtures, and equipment||($0.1)|
|Provisions for impairment||$13.1|
|Gain on sales of real estate||($6.9)|
|FFO available to common stockholders||$251.5|
On a per-share basis, Realty Income reported net income (traditional "earnings") of $0.31 per share and FFO of $0.81 per share. So the company's actual earnings were about 160% higher than its net income might suggest.
Most REITs also report some other variations of FFO. For example, you might see "adjusted FFO" or "normalized FFO," which could make adjustments for one-time expenses or non-recurring income streams. These can be the most useful and accurate picture of how much a REIT earned, but keep in mind that these aren't standardized metrics and the methodology can vary. One REIT's "core FFO" isn't necessarily the same thing as another's.
Continuing the previous example, Realty Income reports adjusted FFO, which makes a few amortization adjustments and also accounts for things like leasing costs and commissions, interest rate swaps, and recurring capital expenditures. Some of these add to the FFO while others subtract.
In all, Realty Income reported an adjusted FFO of $0.82 per share -- a penny higher than the traditional calculation. The company feels that this is the best picture of its performance during the quarter.
The bottom line
There are some valid applications of traditional EPS calculations in the REIT world. For example, REITs need to pay out at least 90% of their taxable income as dividends. EPS is a good indicator of a REIT's taxable income -- the amount that would typically be subject to corporate income taxes in most other types of companies.
The bottom line is that traditional valuation metrics and methods of calculating earnings per share don't translate well to REITs. Consider FFO or one of its variations as the REIT version of "earnings" when analyzing real estate stocks for your portfolio.