Nov
22
2023
What Is Mean Reversion and How Can You Trade It?

What Is Mean Reversion and How Can You Trade It?

By | Growing Wealth, invest, Investing, Terminology | Comments Off on What Is Mean Reversion and How Can You Trade It?

Mean reversion is a mathematical concept which holds that over time statistical measurements return to a long-run normal. In investing, mean reversion holds that while a market or an asset may go up and down in the short-term, over time, it returns to its long-term trend.

If traders expect a market to revert to the mean, they can use that expectation to inform their strategy going forward.

Key Points

•   Mean reversion is a mathematical concept that states assets tend to return to their long-term trends over time.

•   Traders may use mean reversion to inform their strategies and expect assets to return to their historical behaviors.

•   Mean reversion applies not only to individual stocks, but also to sectors, commodities, and foreign currencies.

•   Implementing a mean reversion strategy requires identifying patterns and timing the reversion correctly.

•   Mean reversion strategies depend on regularities staying consistent, and there are risks if structural shifts occur in the market or economy.

What Is Mean Reversion?

When stocks revert to the mean, their returns or other characteristics match what they’ve been over a longer period of time than the recent past. This can mean that a stock that becomes highly volatile may revert back to being less volatile; a stock that becomes quite expensive (meaning its price far outpaces its earnings) can become cheap; and, quite importantly, the other way around. Mean reversion can work in both directions.

The mean reversion concept not only applies to individual shares, but also to whole sectors of the economy or of the stock market, like, say, consumer product companies or pharmaceutical companies or any other chunk of the market that shares enough with each other to be classed together. Alternative assets, such as commodities or foreign currencies can also revert to the mean.

The theory applies to more than just prices, the volatility of a given asset can mean revert, which can matter for trading and pricing more exotic financial products like options and other derivatives.


💡 Quick Tip: Before opening any investment account, consider what level of risk you are comfortable with. If you’re not sure, start with more conservative investments, and then adjust your portfolio as you learn more.

Mean Reversion Strategies

With any generality or principle of the market comes the obvious question: Is there a strategy here? Can this be traded? Mean reversion trading is a strategy based on reversion to the mean happening, basically that stocks or some asset will return to its typical, long-run historical behavior.

Actually working out a mean reversion strategy is not as simple as thinking a certain stock is out of whack and waiting for things to get back to normal, it requires the ability to flag patterns to make an educated guess about when mean reversion will happen.

After all, if you just know that a stock is going to revert to the mean, you can still pile up large losses or miss out on big gains if you can’t time the reversion correctly — go too early and you’ll have to eat the stock being the “wrong” price before reversion to the mean happens, go too late and the gains have already evaporated as the change in price or returns has already occurred.

The Risks of Mean Reversion Strategy

Mean reversion strategies depend on statistical and historical regularites staying, well, regular. There are some that are pretty well validated, although with sharp and scary exceptions, like that stocks tend to go up over time and outperform other asset classes. But mean reversion involves certain relationships between stocks and assets staying true over time.

In some cases, mean reversion never occurs. Companies or sectors can have continually growing returns over a long period of time if there’s some kind of structural shift in the economy or market in which they operate. This can mean that returns increase over time or stay quite high.

This can happen for a few reasons. A company could gain or lose a dominant position in a given market, technological changes can advantage certain firms and disadvantage others, such that returns move permanently (or at least close enough to permanently for a given investment strategy) to a higher level and lower to another. Or there could be a global pandemic that permanently changes the way that companies do business, or long-run inflation that impacts profitability.

How to Implement a Mean Reversion Strategy

There are some basic statistical and financial tools to help create mean reversion strategy. As always, active trading and trying to time the market is risky and sometimes the whole market moves up and down and that can swamp whatever strategy you might have for an individual stock or sector.

Part of implementing a mean reversion strategy is getting a sense of stock trends or a trend trading strategy, whether past movement in a stock up or down is indicative of continuing in that direction.

This can involve trying to discern bullish indicators for stocks, giving you a sense of when stock returns are likely to go up. Often traders combine this strategy with forms of technical analysis, including the use of candlestick patterns.

Recommended: Important Candlestick Patterns to Know

Alternatively, you will need to have a sense of when a stock is underperforming in order to profit from buying it before it reverts to the mean upwards.

Factors in Creating a Mean Reversion Strategy

There are many factors that institutional and retail investors need to consider when devising a mean reversion strategy.

Determining the Mean

In this case, you’ll need to think about what period of time you are using to determine a stock or sector’s “normal” or “average” behavior. This matters because it will determine how long you decide to hold a stock or when you plan to sell it before or after the reversion to the mean occurs.

Timing

To execute a mean reversion strategy, you have to know when a stock’s price movement is sufficient to execute the trade. It helps to determine this point in advance.

Recommended: Understanding Pivot Points for New Investors

Determine the Bounds

What is the “normal” behavior, whether it’s price-to-equity ratio, volatility, or some other metric you’re looking at. To determine whether something is far beyond its mean, either high or low, you need a good sense of its normal range.

Recommended: Support and Resistance: A Beginner’s Guide

Qualitative Factors

Mean reversion and trading reversion to the mean is, of course, a quantitative endeavor. You need to compile statistics and make projections going forward in order to implement the strategy. But you also need to know what’s going on in the “real world” beyond the statistics.

If something is driving prices or volatility or some other metric higher or lower that’s likely to persist over time, mean reversion may not be a great bet. If, however, there’s something truly transient that’s the catalyst for large moves up and down that will then revert to the mean, then maybe the strategy is more likely to work.

Exit Strategy

As with most investments, it’s helpful to have an exit strategy determined ahead of time. This can help you limit your losses in the case that the asset ultimately does not revert to the mean.


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The Takeaway

Mean reversion refers to an asset’s tendency to stick to typical value increases over time. Again, while volatility may play a role in short-term price or value changes, most assets will follow a long-term appreciation line, and despite short-term rises or falls in price, they’ll likely revert to the mean.

Traders who follow mean reversion strategies assume that a specific stock or sector will return to its long-term characteristics. The strategy can be helpful when determining an investing strategy for either individual assets or for a market, overall.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

Photo credit: iStock/LaylaBird

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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Nov
22
2023
What Is Mark to Market and How Does It Work?

Mark to Market Definition and Uses in Account & Investing

By | Growing Wealth, invest, Investing | Comments Off on Mark to Market Definition and Uses in Account & Investing

The term “mark to market” refers to an accounting method used to measure the value of assets based on current market conditions. Mark to market accounting seeks to determine the real value of assets based on what they could be sold for right now.

That can be useful in a business setting when a company is trying to gauge its financial health or get a valuation estimate ahead of a merger or acquisition. Aside from accounting, mark to market also has applications in investing when trading stocks, futures contracts, and mutual funds. For traders and investors, it can be important to understand how this concept works.

Key Points

•   Mark to market is an accounting method used to determine the current value of assets based on market conditions.

•   It is used in business to assess financial health and valuation, as well as in investing for trading stocks, futures contracts, and mutual funds.

•   Mark to market accounting adjusts asset values based on current market conditions to estimate their potential sale value.

•   Pros of mark to market accounting include accurate valuations for asset liquidation, value investing, and establishing collateral value for loans.

•   Cons include potential inaccuracies, volatility skewing valuations, and the risk of devaluing assets in an economic downturn.

What Is Mark to Market?

Mark to market is, in simple terms, an accounting method that’s used to calculate the current or real value of a company’s assets, as noted. Mark to market can tell you what an asset is worth based on its fair market value.

Mark to market accounting is meant to create an accurate estimate of a company’s financial status and value year over year. This accounting method can tell you whether a company’s assets have increased or declined in value. When liabilities are factored in, mark to market can give you an idea of a company’s net worth.


💡 Quick Tip: The best stock trading app? That’s a personal preference, of course. Generally speaking, though, a great app is one with an intuitive interface and powerful features to help make trades quickly and easily.

How Mark to Market Accounting Works

Mark to market accounting works by adjusting the value of assets based on current market conditions. The idea is to determine how much an asset — whether it be a piece of equipment or an investment — could be worth if it were to be sold immediately.

If a company were in a cash crunch, for example, and wanted to sell off some of its assets, mark to market accounting could give an idea of how much capital it might be able to raise. The company would try to determine as accurately as possible what its marketable assets are worth.

In stock trading, mark to market value is determined for securities by looking at volatility and market performance. Specifically, you’re looking at a security’s current trading price then making adjustments to value based on the trading price at the end of the trading day.

There are other ways mark to market can be used beyond valuing company assets or securities. In insurance, for example, the mark to market method is used to calculate the replacement value of personal property. Calculating net worth, an important personal finance ratio, is also a simple form of mark to market accounting.

Mark-to-Market Accounting: Pros and Cons

Mark to market accounting can be useful when evaluating how much a company’s assets are worth or determining value when trading securities. But it’s not an entirely foolproof accounting method.

Mark to Market Pros Mark to Market Cons

•   Can help establish accurate valuations when companies need to liquidate assets

•   Useful for value investors when making investment decisions

•   May make it easier for lenders to establish the value of collateral when extending loans

•   Valuations are not always 100% accurate since they’re based on current market conditions

•   Increased volatility may skew valuations of company assets

•   Companies may devalue their assets in an economic downturn, which can result in losses

Pros of Mark to Market Accounting

There are a few advantages of mark to market accounting:

•   It can help generate an accurate valuation of company assets. This may be important if a company needs to liquidate assets or it’s attempting to secure financing. Lenders can use the mark to market value of assets to determine whether a company has sufficient collateral to secure a loan.

•   It can help mitigate risk. If a value investor is looking for new companies to invest in, for example, having an accurate valuation is critical for avoiding value traps. Investors who rely on a fundamental approach can also use mark to market value when examining key financial ratios, such as price to earnings (P/E) or return on equity (ROE).

•   It may make it easier for lenders to establish the value of collateral when extending loans. Mark to market may provide more accurate guidance in terms of collateral value.

Cons of Mark to Market Accounting

There are also some potential disadvantages of using mark to market accounting:

•   It may not be 100% accurate. Fair market value is determined based on what you expect someone to pay for an asset that you have to sell. That doesn’t necessarily guarantee you would get that amount if you were to sell the asset.

•   It can be problematic during periods of increased economic volatility. It may be more difficult to estimate the value of a company’s assets or net worth when the market is experiencing uncertainty or overall momentum is trending toward an economic downturn.

•   Companies may inadvertently devalue their assets in a downturn. If the market’s perception of a company, industry, or sector turns negative, it could spur a sell-off of assets. Companies may end up devaluing their assets if they’re liquidating in a panic. This can have a boomerang effect and drive further economic decline, as it did in the 1930s when banks marked down assets following the 1929 stock market crash.

Mark to Market in Investing

In investing, mark to market is used to measure the current value of securities, portfolios or trading accounts. This is most often used in instances where investors are trading futures or other securities in margin accounts.

Futures are derivative financial contracts, in which there’s an agreement to buy or sell a particular security at a specific price on a future date. Margin trading involves borrowing money from a brokerage in order to increase purchasing power.

Understanding mark to market is important for meeting margin requirements to continue trading. Investors typically have to deposit cash or have marginable securities of $2,000 or 50% of the securities purchased. The maintenance margin reflects the amount that must be in the margin account at all times to avoid a margin call.

In simple terms, margin calls are requests for more money. FINRA rules require the maintenance margin to be at least 25% of the total value of margin securities. If an investor is subject to a margin call, they’ll have to sell assets or deposit more money to reach their maintenance margin and continue trading.

In futures trading, mark to market is used to price contracts at the end of the trading day. Adjustments are made to reflect the day’s profits or losses, based on the closing price at settlement. These adjustments affect the cash balance showing in a futures account, which in turn may affect an investor’s ability to meet margin maintenance requirements.


💡 Quick Tip: How do you decide if a certain trading platform or app is right for you? Ideally, the investment platform you choose offers the features that you need for your investment goals or strategy, e.g., an easy-to-use interface, data analysis, educational tools.

Mark to Market Example

Futures markets follow an official daily settlement price that’s established by the exchange. In a futures contract transaction you have a long trader and a short trader. The amount of value gained or lost in the futures contract at the end of the day is reflected in the values of the accounts belonging to the short and long trader.

So, assume a farmer takes a short position in 10 soybean futures contracts to hedge against the possibility of falling commodities prices. Each contract represents 5,000 bushels of soybeans and is priced at $5 each. The farmer’s account balance is $250,000. This account balance will change daily as the mark to market value is recalculated. Here’s what that might look like over a five-day period.

Day

 Futures Price Change in Value Gain/Loss Cumulative Gain/Loss Account Balance
1 $5 $250,00
2 $5.05 +0.05 -2,500 -2,500 $247,500
3 $5.03 -0.02 +1,000 -1,500 $248,500
4 $4.97 -0.06 +3,000 +1,500 $251,500
5 $4.90 -0.07 +3,500 +5,000 $255,000

Since the farmer took a short position, a decline in the value of the futures contract results in a positive gain for their account value. This daily pattern of mark to market will continue until the futures contract expires.

Conversely, the trader who holds a long position in the same contract will see their account balance move in the opposite direction as each new gain or loss is posted.

Mark to Market in Recent History

Mark to market accounting can become problematic if an asset’s market value and true value are out of sync. For example, during the financial crisis of 2008-09, mortgage-backed securities (MBS) became a trouble spot for banks. As the housing market soared, banks raised valuations for mortgage-backed securities. To increase borrowing and sell more loans, credit standards were relaxed. This meant banks were carrying a substantial amount of subprime loans.

As asset prices began to fall, banks began pulling back on loans to keep their liabilities in balance with assets. The end result was a housing bubble which sparked a housing crisis. During this time, the U.S. economy would enter one of the worst recessions in recent history.

The U.S. Financial Accounting Standards Board (FASB) eased rules regarding the use of mark to market accounting in 2009. This permitted banks to keep the values of mortgage-backed securities on their balance sheets when the value of those securities had dropped significantly. The measure meant banks were not forced to mark the value of those securities down.

Can You Mark Assets to Market?

The FASB oversees mark to market accounting standards. These standards, along with other accounting and financial reporting rules, apply to corporate entities and nonprofit organizations in the U.S. But it’s possible to use mark to market principles when making trades.

If you’re trading futures contracts, for instance, mark to market adjustments are made to your cash balance daily, based on the settlement price of the securities you hold. Your cash balance will increase or decrease based on the gains or losses reported for that day.

If the market moves in your favor, your account’s value would increase. But if the market moves against you and your futures contracts drop in value, your cash balance would adjust accordingly. You’d have to pay attention to maintenance margin requirements in order to avoid a margin call.

Which Assets Are Marked to Market?

Generally, the types of assets that are marked to market are ones that are bought and sold for cash relatively quickly — otherwise known as marketable securities. Assets that can be marked to market include stocks, futures, and mutual funds. These are assets for which it’s possible to determine a fair market value based on current market conditions.

When measuring the value of tangible and intangible assets, companies may not use the mark to market method. In the case of equipment, for example, they may use historical cost accounting which considers the original price paid for an asset and its subsequent depreciation. Meanwhile, different valuation methods may be necessary to determine the worth of intellectual property or a company’s brand reputation, which are intangible assets.

Mark to Market Losses

Mark to market losses occur when the value of an asset falls from one day to the next. A mark to market loss is unrealized since it only reflects the change in valuation of asset, not any capital losses associated with the sale of an asset for less than its purchase price. The loss happens when the value of the asset or security in question is adjusted to reflect its new market value.

Mark to Market Losses During Crises

Mark to market losses can be amplified during a financial crisis when it’s difficult to accurately determine the fair market value of an asset or security. When the stock market crashed, for instance, in 1929, banks were moved to devalue assets based on mark to market accounting rules. This helped turn what could have been a temporary recession into the Great Depression, one of the most significant economic events in stock market history.

Mark to Market Losses in 2008

During the 2008 financial crisis, mark to market accounting practices were a target of criticism as the housing market crashed. The market for mortgage-backed securities vanished, meaning the value of those securities took a nosedive.

Banks couldn’t sell those assets, and under mark to market accounting rules they had to be revalued. As a result banks collectively reported around $2 trillion in total mark to market losses.

The Takeaway

Mark to market is, as discussed, an accounting method that’s used to calculate the current or real value of a company’s assets. Mark to market is a helpful principle to understand, especially if you’re interested in futures trading.

When trading futures or trading on margin, it’s important to understand how mark to market calculations could affect your returns and your potential to be subject to a margin call. As always, if you feel like you’re in the weeds, it can be beneficial to speak with a financial professional for guidance.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

FAQ

Is mark to market accounting legal?

Mark to market account is a legal accounting practice, and is overseen by the FASB. Though it has been used in the past to cover financial losses, it remains a legal and viable method.

Is mark to market accounting still used?

Yes, mark to market accounting is still used both by businesses and individuals for investments and personal finance needs. In some sectors of the economy, it may even remain as one of the primary accounting methods.

What are mark to market losses?

Mark to market losses are losses that are generated as a result of an accounting entry, as opposed to a loss generated by the sale of an asset. The loss is incurred, under mark to market accounting, when the value of an asset declines, not when it is sold for less than it was purchased.

Photo credit: iStock/Drazen_

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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Nov
22
2023
businessman on smartphone

Guide to Calculating EPS and Why It Matters

By | Growing Wealth, invest, Investing, Terminology | Comments Off on Guide to Calculating EPS and Why It Matters

Earnings per share (EPS) tells investors a company’s ability to produce income for shareholders, and relates to its profitability. To calculate EPS, investors can use a ratio that takes a company’s quarterly or annual net income and divide it by the number of outstanding shares of stock on the market.

Knowing a stock’s earnings per share can be a valuable portfolio benchmarking tool. Think of EPS as GPS for where a public company is on the value map, based on how profitable it has been. Further, knowing an investment’s EPS gives investors — and portfolio managers — a good indicator of a stock’s performance over a specific period of time and its potential share price performance in the near future.

Key Points

•   Earnings per share (EPS) is a ratio that measures a company’s ability to generate income for shareholders.

•   EPS is calculated by dividing a company’s net income by the number of outstanding shares of stock.

•   EPS is a valuable tool for benchmarking a company’s profitability and assessing its potential share price performance.

•   Basic EPS includes all outstanding stock shares, while diluted EPS considers additional assets like convertible securities.

•   EPS may help investors evaluate a company’s financial health, make investment decisions, and assess risk.

What Is Earnings Per Share (EPS)?

The starting point for any conversation about the EPS ratio is the earnings report companies issue to regulators, shareholders, and potential investors. Earnings reports play a major role, if not the starring role, during earnings season.

Publicly traded companies must, by law, report their earnings quarterly and annually. Earnings represent the net income a company generates (after taxes and after expenses are deducted), along with an estimate of what profits or losses can be expected going forward.

Typically, investment analysts, money managers and investors look at earnings as a major component of a company’s profit potential, with earnings per share a particularly useful measurement tool when gauging a company’s financial prospects.

While a company’s earnings call represents a publicly traded company’s revenues, minus operating expenses, earnings per share is different.

EPS indicates a firm’s earnings for investors, divided by the company’s number of remaining shares. Earnings per share is perhaps most optimal when comparing EPS rates of publicly traded firms operating in the same industry.

It is likely not, however, the only investment measurement tool when researching stocks and funds. Other key indicators, like share price, market share, market capitalization, dividend growth, and historical performance may also be added to the investment assessment mix. In all, though, it’s an important tool that can help determine the investing risk at play when making investing decisions.

If you’re wondering how to find earnings per share, investors can find a company’s quarterly and yearly EPS by visiting the firm’s investor relations page on its website or by plugging in the stock’s ticker symbol on major business and finance media platforms.


💡 Quick Tip: Before opening an investment account, know your investment objectives, time horizon, and risk tolerance. These fundamentals will help keep your strategy on track and with the aim of meeting your goals.

Basic and Diluted EPS

When companies report earnings per share, they may do so in two forms: basic EPS or diluted EPS. Each has key distinctions that investors should know about. Basic EPS is a good barometer of a firm’s financial health, while diluted EPS represents a deeper dive into a company’s financial metrics and its use of alternative assets like convertible securities.

Basic

Basic earnings per share, or basic EPS, includes all of a publicly traded company’s outstanding stock shares.

Diluted

Diluted earnings per share, or diluted eps, includes all of a company’s outstanding stock shares, plus its investable assets, like stock options, stock warrants, and other forms of convertible investments tied to a company’s financial performance that could become common stocks one day.

One big takeaway for both EPS models is that any major deviation between basic and diluted EPS calculations should be considered a warning sign to investors, as it indicates that a company’s use of convertible securities is complicated and still in flux.

That scenario may indicate that the company isn’t in an ideal position to provide accurate share value to the investing public at a given time.

Why Is EPS Important to Investors

EPS calculations are not only a snapshot of a company’s profit performance, but they can also be used to evaluate a company’s stock price going forward. Even a moderate increase in EPS may indicate that a company’s profit potential is on the upside, and investors may take that as a sign to buy the company’s stock.

Conversely, a small decrease in a company’s EPS from quarter to quarter may trigger a red flag among investors, who could view a downward EPS trend as a larger profit issue and shy away from buying the company’s stock.

In short, the higher the EPS, the more attractive that company’s stock generally is to investors. But the higher a stock’s EPS, the more expensive its shares are likely to be.

Once investors have an accurate EPS figure, they can decide if a stock is priced fairly and make an appropriate investment decision.

What Is Considered a Good EPS Ratio?

There’s no hard and fast figure to point to when trying to determine a good EPS ratio. It’s perhaps better practice to look, in general, for a higher number. Context is important, too, because whether an EPS is good may depend on the expectations surrounding it.

Companies grow at different rates, and some are in different stages of growth than others. With that in mind, you might expect a different EPS for, say, a tech startup than you would for a decades-old auto manufacturer. So, there are differences and contexts to take into consideration.

But again, it may be best to look for a high number — or, to do some research to figure out what analysts and experts are looking for in terms of a specific company’s EPS. Again, this can all help you determine whether a stock is right for your portfolio and strategy in accordance with your tolerance for risk.


💡 Quick Tip: How to manage potential risk factors in a self directed investment account? Doing your research and employing strategies like dollar-cost averaging and diversification may help mitigate financial risk when trading stocks.

Earnings Per Share Ratio Considerations

Investors should prepare to dig deeper and examine what factors influence EPS figures. These factors are at the top of that list:

•   EPS numbers can rise or fall significantly based on earnings’ rise or fall, or as the number of company shares rises or falls.

•   A company’s earnings may rise because sales are surging faster than expenses, or if company managers succeed in curbing operations costs. Additionally, investors may get a “false read” on EPS if too many company expenses are shed from the EPS calculation.

•   A company’s number of outstanding shares may fall if a company engages in significant stock share buybacks. Correspondingly, shares outstanding may jump when a firm issues new stock shares.

•   A company’s profit margins are also a big influencer on EPS. A company that is losing money usually has a negative EPS number. (Then again, that may send a wrong signal to investors. The company could be on the path to profits, and that trend may not show up in an EPS calculation.)

•   A price to earnings ratio is another highly useful metric to evaluate a stock’s share growth potential. Investors can find a P/E ratio through a proper calculation of EPS (“P” is the price per share; “E” refers to EPS), though it’s easy to look up a P/E ratio on any site that aggregates stock information.

EPS can be reported for each quarter or fiscal year, or it can be projected into the future with a forward EPS.

How to Calculate EPS

The EPS formula is fairly simple, and it can be used in a couple of different methods, too. The most common way to accurately gauge an EPS figure is through an end-of-period calculation.

EPS Formula

The EPS formula is a company’s net income, minus its preferred dividends, divided by the number of shares outstanding. It looks like this:

EPS = (net income – preferred dividends) / outstanding shares

EPS is perhaps usually calculated using preferred dividends, but it can be calculated without them, too. Here are a couple of examples:

Example With Preferred Dividends

Investors can calculate EPS by subtracting a stock’s total preferred dividends from the company’s net income. Then divide that number by the end-of-period stock shares that are outstanding.

Basic EPS = (net income – preferred dividends) / weighted average number of common shares outstanding

For example, ABC Co. generates a net income of $2 million in a quarter. Simultaneously, the company rolls out $275,000 in preferred dividends and has 12 million outstanding shares of stock. In that calculation, knowing that shares of common stock are equal in value, the company’s earnings per share is $0.14.

(2,000,000 – 275,000) ÷ 12,000,000＝ 0.14

Example Without Preferred Dividends

For smaller publicly traded companies with no preferred dividends, the EPS calculation is more straightforward.

Basic EPS = net income / weighted average number of common shares outstanding

Let’s say DEF Corp. has generated a net income of $50,000 for the year. As the company has no preferred shares outstanding and has 5,000 weighted average shares on an annual basis, its earnings per share is $10.

50,000 ÷ 5,000＝ 10

In any EPS calculation, preferred dividends must be severed from net income. That’s because earnings per share is primarily designed to calculate the net income for holders of common stock.

Additionally, in most EPS end-of-period calculations, a company is mostly likely to calculate EPS for end-of-year financial statements. That’s because companies may issue new stock or buy back existing shares of company stock.

In those instances, a weighted average of common stock shares is required for an accurate EPS assessment. (A weighted average of a company’s outstanding shares can provide more clarity because a fixed number at any given time may provide a false EPS outcome, as share prices can be volatile and change quickly on a day-to-day basis.)

The most commonly used EPS share model calculation is the “trailing 12 months” formula, which tracks a company’s earnings per share by totaling its EPS for the previous four quarters.

The Takeaway

Earnings per share (EPS) can be calculated by investors to get a better sense of a company’s ability to produce income for shareholders. To calculate EPS, investors can use a ratio that takes a company’s quarterly or annual net income and divide it by the number of outstanding shares of stock on the market. There are different variations of the calculation, too.

Earnings trends, up or down, make earnings per share one of the most valuable metrics for assessing investments. Four or five years of positive EPS activity is considered an indicator that a company’s long-term financial prospects are robust and that its share growth should continue to rise.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).


For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

FAQ

How do you calculate EPS by year?

To calculate EPS by year, investors can use the formula that subtracts preferred dividends from net income, and then divide that number by the weighted average of common shares outstanding for the given year.

What is a good EPS ratio?

Each company is different, as is the context surrounding it, so there is no general rule about what makes a “good” EPS ratio for any given stock. Instead, investors should gauge analyst expectations, and consider a company’s age, among other things, to determine if its EPS is good or bad.

What are the two ways to calculate EPS?

Earnings per share (EPS) can be calculated with preferred dividends, or without preferred dividends, depending on the specific company.

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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Is a Reverse Stock Split Good or Bad?

By | Growing Wealth, invest, Investing | Comments Off on Is a Reverse Stock Split Good or Bad?

A stock split allows companies to increase the number of shares offered to investors, without changing shareholder equity. Rather than issuing new shares, companies may split stock to reduce prices. A reverse stock split can be used to condense and combine stock shares. This type of stock split is often done to increase share prices.

While a reverse stock split can improve a stock’s price in the near term, it could be a sign that a company is struggling financially. Large fluctuations in stock pricing associated with a reverse stock split could also cause investors to lose money. For investors who are concerned about managing risk inside their investment portfolio, it’s important to understand how a reverse stock split works, along with the pros and cons.

Key Points

•   A reverse stock split reduces the number of shares on the market and can be used to boost share prices in the short-term.

•   Companies may execute a reverse stock split to attract new investors, or meet minimum bid price requirements.

•   Investors don’t usually lose money on a stock split, but the value of their shares and dividend payments may change.

•   Whether a reverse stock split is good or bad depends on the company’s financial situation and goals.

•   A reverse stock split may create opportunities for growth or result in losses if the new price doesn’t hold.

What Is a Reverse Stock Split?

A stock split increases the number of shares available to trade without affecting an investor’s equity stake in those shares. For example, if you own 100 shares of XYZ stock and the company initiates a two-for-one split, you’d own 200 shares of stock once it’s completed. At the same time, the stock’s price would be cut in half. So if your shares were worth $100 before, they’d be worth $50 each afterward.

A reverse stock split moves in the opposite direction. Companies can use different ratios for executing reverse stock splits. For example, a company could decide to initiate a reverse split that converts every 10 shares of stock into a single share. So if you owned 100 shares before the reverse split, you’d own 10 shares afterward.

The stock’s price would also change proportionately. So if each share of stock was valued at $10 before the split, those shares would be worth $100 afterward. Your overall investment would still be valued at $1,000; the only thing that changes is the number of shares you own.

Why Do Companies Execute Reverse Stock Splits?

There are different reasons why a company may choose to execute a reverse stock split. Most often, it’s used as a tool for increasing the share prices of stock.

Raising stock prices is a tactic that can be used to attract new investors if the company believes the current trading price is too low. A higher share price could send a signal to the market that the company is worth investing in. Companies may also choose to reverse split stocks to meet minimum bid price requirements in order to stay listed on a major stock exchange.

Reverse stock splits don’t affect a company’s market capitalization, which represents the total number of a company’s outstanding shares multiplied by its current market price per share. But by consolidating existing shares into fewer shares, those shares can become more valuable.

Do Investors Lose Money on a Stock Split?

Investors don’t usually lose money on a stock split. Avoiding losses is part of investing strategically, and it makes sense if investors wonder how a forward stock split or a reverse stock split could impact them financially.

A stock split itself doesn’t cause an investor to lose money, because the total value of their investment doesn’t change. What changes is the number of shares they own and the value of each of those shares.

For example, if you have $1,000 invested before a forward stock split or a reverse stock split, you would still have $1,000 afterward. But depending on which way the stock split moves, you may own more or fewer shares and the price of those shares would change correspondingly.

If you own a stock that pays stock dividends, those dividend payments would also adjust accordingly. For instance, in a forward two-for-one split of a stock that’s currently paying $2 per share in dividends, the new payout would be $1 per share. If you own a stock that pays $1 per share in dividends, then undergoes a reverse stock split that combines five shares into one, your new dividend payout would be $5 per share.

Are Reverse Stock Splits Good or Bad?

Whether a reverse stock split is good or bad can depend on why the company chose to initiate it and the impacts it has on the company’s overall financial situation.

At first glance, a reverse stock split can seem like a red flag. If a company is trying to boost its share price to try and attract new investors, that could be a sign that it’s desperate for cash. But there are other indicators that a company is struggling financially. A poor earnings call or report, or a diminishing dividend could also be clues that a company is underperforming.

In terms of outcomes, there are two broad paths that can open up following a reverse stock split.

A Reverse Stock Split Could Create Opportunities

One potential path creates new opportunities for the company to grow and strengthen financially, but this is usually dependent on taking other measures. For example, if a company is also taking steps to reduce its debt load or improve earnings, then a reverse stock split could yield long-term benefits with regard to pricing.

A Reverse Stock Split Could Result in Losses

On the other hand, a reverse stock split could result in losses to investors if the new price doesn’t stick. If stock prices fall after a reverse stock split, that means an investor’s new combined shares become less valuable. This scenario may be likely if the company isn’t making other efforts to improve its financial situation, or if the efforts they are making fail.

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Should I Sell Before a Stock Split?

There are many factors that go into deciding when to sell a stock. Whether it makes sense to sell before a stock split or after can depend on what other signs the company is giving off with regard to its financial health and how an investor expects it to perform after the split.

Investors who have shares in a company that has a strong track record overall may choose to remain invested. Even though a split may result in a lower share price in the near term, their investments could grow in value if the price continues to climb after the split.

With a reverse stock split, a decision to sell (or not sell) may hinge on why the company is executing the split. If a reverse stock split is being done to raise prices and attract new investors, it’s important to consider what the company’s goals are for doing so.

Taking a look at the company’s finances and comparing things like price to earnings (P/E) ratio, earnings per share (EPS) and other key ratios that may be gleaned by reading the company’s earnings report, can give you a better idea of which direction things may be headed.

The Takeaway

A reverse stock split involves a company reducing the overall number of shares on the market, likely in an effort to boost share prices. A reverse stock split itself shouldn’t have an immediate or outsized impact on an investor — their overall investment value remains the same, even as stocks are consolidated at a higher price. But the reasons behind the reverse stock split are worth investigating, and the split itself has the potential to drive stock prices down.

Stock splits are something investors may encounter from time to time. Understanding what the implications of a forward or reverse stock split are and what they can tell you about a company can help an investor develop a strategy for managing them.

Ready to invest in your goals? It’s easy to get started when you open an investment account with SoFi Invest. You can invest in stocks, exchange-traded funds (ETFs), mutual funds, alternative funds, and more. SoFi doesn’t charge commissions, but other fees apply (full fee disclosure here).

For a limited time, opening and funding an Active Invest account gives you the opportunity to get up to $1,000 in the stock of your choice.

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
Claw Promotion: Customer must fund their Active Invest account with at least $25 within 30 days of opening the account. Probability of customer receiving $1,000 is 0.028%. See full terms and conditions.

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Tax Loss Carryforward

Tax Loss Carryforward

By | Growing Wealth, invest, Investing | Comments Off on Tax Loss Carryforward

A tax loss carryforward is a special tax rule that allows capital losses to be carried over from one year to another. In other words, an investor can take capital losses realized in the current tax year to offset gains or profits in a future tax year.

Investors can use a capital loss carryforward to minimize their tax liability when reporting capital gains from investments. Business owners can also take advantage of loss carryforward rules when deducting losses each year. Knowing how this tax provision works and when it can be applied is important from an investment tax savings perspective.

Key Points

•   Tax loss carryforward allows investors to offset capital losses against future gains, reducing tax liability.

•   Investors can take advantage of tax loss carryforward by deducting capital losses from taxable income, reducing their overall tax liability.

•   Capital loss carryforward rules prohibit violating the wash-sale rule and have limitations on deductions.

•   Net operating loss carryforward is similar to capital loss carryforward for businesses operating at a loss.

•   Losses can be carried forward indefinitely at the federal level, but capital losses must be used to offset capital gains in the same year.

What Is Tax Loss Carryforward?

Tax loss carryforward, sometimes called capital loss carryover, is the process of carrying forward capital losses into future tax years. A capital loss occurs when you sell an asset for less than your adjusted basis. Capital losses are the opposite of capital gains, which are realized when you sell an asset for more than your adjusted basis.

Adjusted basis means the cost of an asset, adjusted for various events (i.e., increases or decreases in value) through the course of ownership.

Whether a capital gain or loss is short-term or long-term depends on how long you owned it before selling. Short-term capital losses and gains apply when an asset is held for one year or less, while long-term capital gains and losses are associated with assets held for longer than one year.

The Internal Revenue Service (IRS) allows certain capital losses, including losses associated with personal or business investments, to be deducted from taxable income.

There are limits on the amount that can be deducted each year, however, depending on the type of losses being reported. For example, the IRS allows investors to deduct up to $3,000 from their taxable income if the capital loss is from the sales of assets like stocks, bonds, or real estate. If capital losses exceed $3,000, the IRS allows investors to carry capital losses forward into future years and use them to reduce potential taxable income.

💡 Recommended: SoFi’s Guide to Understanding Your Taxes

How Tax Loss Carryforwards Work

A tax loss carryforward generally allows you to report losses realized on assets in one tax year on a future year’s tax return. Realized losses differ from unrealized losses or gains, which are the change in an investment’s value compared to its purchase price before an investor sells it.

IRS loss carryforward rules apply to both personal and business assets. The main types of capital loss carryovers allowed by the Internal Revenue Code are capital loss carryforwards and net operating loss carryforwards.

Capital Loss Carryforward

IRS rules allow investors to “harvest” tax losses, meaning they use capital losses to offset capital gains. An investor could sell an investment at a capital loss, then deduct that loss against capital gains from other investments to reduce taxable income, assuming they don’t violate the wash-sale rule.

The wash-sale rule prohibits investors from buying substantially identical investments within the 30 days before or 30 days after the sale of a security for the purpose of tax-loss harvesting.

If capital losses are equal to capital gains, they will offset one another on your tax return, so there’d be nothing to carry over. For example, a $5,000 capital gain would cancel out a $5,000 capital loss and vice versa.

However, if capital losses exceed capital gains, investors can deduct a portion of the losses from their ordinary income to reduce tax liability. Investors can deduct the lesser of $3,000 ($1,500 if married filing separately) or the total net loss shown on line 21 of Schedule D (Form 1040). But any capital losses over $3,000 can be carried forward to future tax years, where investors can use capital losses to reduce future capital gains.

To figure out how to record a tax loss carryforward, you can use the Capital Loss Carryover Worksheet found on the IRS’ Instructions for Schedule D (Form 1040) .

💡 Recommended: A Guide to Tax-Efficient Investing

Net Operating Loss Carryforward

A net operating loss (NOL) occurs when a business has more deductions than income. Rather than posting a profit for the year, the company operates at a loss. Business owners may be able to claim a NOL deduction on their personal income taxes. Net operating loss carryforward rules work similarly to capital loss carryforward rules in that businesses can carry forward losses from one year to the next.

According to the IRS, for losses arising in tax years after December 31, 2020, the NOL deduction is limited to 80% of the excess of the business’s taxable income. To calculate net operating loss deductions for your business, you first have to omit items that could limit your loss, including:

•   Capital losses that exceed capital gains

•   Nonbusiness deductions that exceed nonbusiness income

•   Qualified business income deductions

•   The net operating loss deduction itself

These losses can be carried forward indefinitely at the federal level.

Note, however, that the rules for NOL carryforwards at the state level vary widely. Some states follow federal regulations, but others do not.

How Long Can Losses Be Carried Forward?

According to IRS tax loss carryforward rules, capital and net operating losses can be carried forward indefinitely. Before the Tax Cuts and Jobs Act of 2017, business owners were limited to a 20-year window when carrying forward net operating losses.

It’s important to remember that capital loss carryforward rules don’t allow you to roll over losses. IRS rules state that you must use capital losses to offset capital gains in the year they occur. You can only carry capital losses forward if they exceed your capital gains for the year. The IRS also requires you to use an apples-to-apples approach when applying capital losses against capital gains.

For example, you’d need to use short-term capital losses to offset short-term capital gains. You couldn’t use a short-term capital loss to balance out a long-term capital gain or a long-term capital loss to offset a short-term capital gain. This rule applies because short- and long-term capital gains are subject to different tax rates.

Example of Tax Loss Carryforward

Assume that you purchase 100 shares of XYZ stock at $50 each for a total of $5,000. Thirteen months after buying the shares, their value has doubled to $100 each, so you decide to sell, collecting a capital gain of $5,000.

Suppose you also hold 100 shares of ABC stock, which have decreased in value from $70 per share to $10 per share over that same period. If you decide to sell ABC stock, your capital losses will total $6,000 – the difference between the $7,000 you paid for the shares and the $1,000 you sold them for.

You could use $5,000 of the loss of ABC stock to offset the $5,000 gain associated with selling your shares in XYZ to reduce your capital gains tax. Per IRS rules, you could also apply the additional $1,000 loss to reduce your ordinary income for the year.

Now, say you also have another stock you sold for a $6,000 loss. Because you already have a $1,000 loss and there is a $3,000 limit on deductions, you could apply up to $2,000 to offset ordinary income in the current tax year, then carry the remaining $4,000 loss forward to a future tax year, per IRS rules. This is an example of tax loss carryforward. All of this assumes that you don’t violate the wash-sale rule when timing the sale of losing stocks.

💡 Recommended: What to Know about Paying Taxes on Stocks

The Takeaway

If you’re investing in a taxable brokerage account, you must include tax planning as part of your strategy. Selling stocks to realize capital gains could result in a larger tax bill if you’re not deducting capital losses at the same time. With tax-loss harvesting, assuming you don’t violate the wash sale rule, it’s possible to carry forward investment losses to help reduce the tax impact of gains over time. This applies to personal as well as business gains and losses. Thus, understanding the tax loss carryforward provision may help reduce your personal and investment taxes.

If you’re interested in building a portfolio with financial guidance, it may help to open an online brokerage account with SoFi Invest®. With SoFi, you can trade stocks, exchange-traded funds (ETFs), and fractional shares with no commissions. Even better, as a SoFi Member, you have access to financial professionals who can offer complimentary guidance and answer your most pressing investing questions.

Take a step toward reaching your financial goals with SoFi Invest.

Photo credit: iStock/bymuratdeniz

SoFi Invest®

INVESTMENTS ARE NOT FDIC INSURED • ARE NOT BANK GUARANTEED • MAY LOSE VALUE

SoFi Invest encompasses two distinct companies, with various products and services offered to investors as described below: Individual customer accounts may be subject to the terms applicable to one or more of these platforms.
1) Automated Investing and advisory services are provided by SoFi Wealth LLC, an SEC-registered investment adviser (“SoFi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC.
2) Active Investing and brokerage services are provided by SoFi Securities LLC, Member FINRA (www.finra.org)/SIPC(www.sipc.org). Clearing and custody of all securities are provided by APEX Clearing Corporation.
For additional disclosures related to the SoFi Invest platforms described above please visit SoFi.com/legal.
Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

External Websites: The information and analysis provided through hyperlinks to third-party websites, while believed to be accurate, cannot be guaranteed by SoFi. Links are provided for informational purposes and should not be viewed as an endorsement.

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