Earnings Per Share, or EPS, is an important measure of profitability that investors use when analyzing a company to understand how much a company earns for each common share and how it performs compared to its rivals and the broad industry.
Profitability is a key consideration while investing in the stock markets. And investing without profit does not make sense, does it? Thus, figuring out a company's earnings per share, or EPS, is a helpful way to assess its profitability. As a result, for a very long time, companies and investors have seen it as the ultimate level of financial achievement.
Companies' financial health can be evaluated using multiple ratios and methods. Earnings per share (EPS) is one of the most popular financial metrics used to determine a company's performance and stock value. Understanding what EPS is and how it is calculated could help you make better informed investment decisions.
Earnings Per Share (EPS) – Key Takeaways
- Earnings Per Share, abbreviated EPS, is a financial metric used to determine a company's net profits that are attributable to its common shareholders on a per-share basis.
- EPS is the ratio of a company's net income to the weighted average number of common shares outstanding.
- Typically, a higher EPS ratio is perceived positively by stock investors as it suggests that the company is more profitable per share (and vice versa).
EPS Meaning – What is EPS?
Earnings per share, or EPS, is a common financial ratio calculated by dividing a company's annualized net profit (minus operation expenses) by the total number of outstanding common shares. Investors frequently use earnings per share (EPS), to calculate the value of a company. In general, a business is considered as more profitable by investors if its EPS is higher.
To put it simply, earnings per share (EPS) is a measure of a company's profitability. Therefore, the amount that each share of stock would get if a company's profit was divided to its shareholders at the end of the year is what is commonly referred to as the earning per share (EPS).
This value is often used by investors to determine if it makes sense to invest in a certain company or not. When investors compare a company's EPS against other businesses in the same industry, they do it to determine whether the stock is reasonably valued or not.
Beyond determining a company's profitability per share, EPS can be used for other purposes as well. The Price-to-Earnings (P/E) ratio, which divides a company's share price by its earnings per share, and the Price/Earnings-to-Growth (PEG) ratio, which divides a company's P/E by its growth rate over a specific period, are two other valuation metrics that rely on the EPS.
How to Calculate Earnings per Share – EPS Formula
There are a couple of methods for calculating a company's EPS. According to the first method, you need to subtract any preferred dividends from the company's net income and divide them by the end-of-period shares outstanding. The other option is to deduct preferred dividends from net income and divide by the weighted average of outstanding shares.
The basic formulas to calculate EPS are:
EPS = (Net Income - Preferred Dividends) / Common Shares Outstanding or,
EPS = (Net Income – Dividends on Preferred Stock) / Average Outstanding Shares, where:
- Net Income = total earnings minus expenses and taxes.
- Dividends on Preferred Stock = stock dividends that were distributed to preferred stockholders prior to the distribution of shares to common stockholders.
- Average Outstanding Shares = the weighted average number of shares outstanding throughout the reporting period, that are determined by dividing the total number of outstanding shares at the start and end of a specified period divided by two.
EPS Formula Example
To calculate the EPS in a basic example, let's assume that a company had net income of $10,000,000 for the year and that no preferred shares were outstanding. Throughout the year, the company had 500,000 shares of common stock outstanding.
EPS formula calculation is done as follows:
($10,000,000 - 0) / 500,000 = $20.0
In general, a company's public filings provide the numbers you need to calculate EPS on your own. Subtract any preferred dividends that may exist from the net income for the year then divide this figure by the total number of outstanding shares of stock.
Types of EPS & Factors Influencing the Earning Per Share
The conventional earnings per share calculation is commonly known as basic EPS. However, there are at least other 3 types of earnings per share, each emphasizing a distinct facet of this financial measure. The most crucial thing to keep in mind is that each unique EPS could affect a company's stock valuation and may suggest that it is overvalued, fairly valued, or undervalued.
Diluted EPS
This takes into consideration the potential dilution from all dilutive securities, including stock options, convertible preferred stock, and convertible bonds. These securities could increase the number of outstanding shares if converted into common shares.
EPS from continuing operations
This type of EPS excludes accounting adjustments, extraordinary items, and discontinued operations. It only contains EPS from daily operations.
EPS excluding extraordinary items
Items that are not typical of a business's operations, like the recorded gain or loss on the sale of a sizable asset, are excluded from the EPS calculation because they could distort the EPS calculation result.
EPS vs. Diluted EPS
The main difference between diluted EPS and basic EPS is that the first takes employee stock options and convertible debt into account. Diluted EPS, according to some investors, may provide a more realistic picture of a company's financial stability than basic EPS. This is because it typically raises the number of shares, which lowers diluted EPS relative to basic EPS.
Diluted EPS Formula
Diluted EPS = (Net Income - Preferred Dividends) / (Common Shares + Diluted Shares)
The number of shares of stock that would remain after all convertible securities issued by a corporation were converted to common stock is known as diluted shares. Convertible bonds, preferred stock, and employee stock options are just a few types of convertible securities.
Variables Impacting the EPS
The number of shares that a company has issued has a significant impact on its EPS. A company's EPS will usually decrease as the total number of issued shares increases. In contrast, the EPS will usually increase if the total number of shares available decreases. However, the earnings per share (EPS) may also be impacted by other variables.
Stock buybacks
Through stock buybacks, companies can reduce the number of common. This occurs when a company buys back its own stock from investors and cancels the shares it has previously bought. As a result, there are fewer outstanding shares available overall, which increases the company's EPS.
Company Revenue
Regardless of whether a company's increases are due to higher sales or lower expenses, a boost in revenue or profits will raise its earnings per share (EPS). The contrary is also true. In general, a company's EPS will decrease if its revenue and related earnings drop.New issuance
By issuing new shares, companies can raise the total number of common shares in circulation. A company's EPS will decrease if the number of outstanding shares increases as result of new shares issuance.Stock Split
Companies can perform a stock split to expand the number of available shares. Although market cap is not affected, a company's EPS may drop, as a stock split can have an impact on a company's share price, which is determined by how the market perceives it.
How to use EPS in Stock Investing
EPS is one among the most important indicators that investors use when picking stocks, as it is a way to gauge how well your preferred companies are performing. You can find EPS data in a company’s earnings report. While reading an earnings report there are two main aspects related to the EPS that investors usually focus on:
Current Earnings Per Share Data
The current EPS figures are derived from four quarters of data. The standard approach is to look at the past two quarters and forecast the next two quarters. This means that you can get a sense of a company's current performance by combining past and future data.
Future Earnings Per Share Data
Future EPS numbers are based on projections. Analysts assess the forecasts for four quarters, just like they do for the other earnings per share calculations. Investors want to know how successful a company might be in the upcoming months, thus information on future earnings per share might be important.
While EPS is important, it shouldn't be the only information you consider in your analysis. For a more complete evaluation, you can also use the following additional performance indicators and data elements when performing a stock fundamental analysis:
- Share price – How do you think the current share price reflects the company’s true value? Is it undervalued, overvalued or fairly valued?
- Industry and economics – What are the current dynamics of the broad industry or sector where the company is involved? Additionally, you need to consider the overall economy and its potential impact on a company's success.
- Company's financials – What is its revenue, and what percentage of that revenue is profit? What risks and liabilities does the company face? Does the business turn a profit or a loss?
- Strategy and direction – What do executives and analysts expect to happen in the upcoming months? Read the most recent guidance in the earnings report in addition to a company's mission statement and plan.
Although EPS is a helpful metric, it is better to correlate it with each of these or other indicators to provide a more comprehensive picture of a company's current circumstances and future.
What is a Good EPS?
There are no strict guidelines for determining if an EPS is good or bad. However, there are several variables determining whether an EPS is more or less attractive to investors, including the company's recent performance compared to its rivals and the broad industry. Investors typically evaluate an EPS in relation to the consensus of analysts' EPS forecasts for a stock to determine if it is good or poor. For instance, a rising EPS may be considered good, but the stock price may drop if it falls short of the analysts' forecast price target. If a company's EPS increases less than anticipated, its stock price may decline even if its EPS increases. It can also be the other way around. Even if a company's EPS is dropping, its stock price may increase if the decline is less than what investors anticipated.
Additionally, in general, a good EPS is defined more by its change from year to year than by its absolute value. Every year, a company's EPS should rise in absolute terms, together with an increase in the rate of those gains.
Can Earnings Per Share (EPS) be Negative?
A company's EPS can be negative if its income is negative. When it comes to mature businesses, negative earnings may not be a good signal. However, a few years of declining profits may be typical for start-ups. To increase their market share, new companies going through growth stages frequently need to take out loans.
In such circumstances, negative income is a possible outcome, but it's not always a terrible thing. A developing company with negative earnings can still be a smart investment if is using borrowed funds wisely and has a solid business plan that may turn a profit soon.
However, if a more established company with a track record of good profitability has negative earnings for several years, it may be losing market share and may be on the verge of bankruptcy, which could cause the stock to lose all of its value.
EPS' Advantages & Limitations
EPS (Earnings Per Share) is a popular financial metric that can give investors useful information. However, using it as a gauge of a business's financial health has both benefits and drawbacks.
Earnings Per Share Advantages
- It is a commonly used metric that is easily accessible to investors.
- EPS is simple to understand and provides an instant overview of a company's profitability.
- It can help investors make better informed investing decisions.
- It's a handy tool for comparing companies within the same industry/sector.
- Could provide an indication of a company’s financial health, as well as of its past performance.
Earnings Per Share Limitations
- It can be manipulated through buybacks or other means.
- It does not consider other variables such as cash flow, debt or capital expenditures (CapEx) that could also impact a company’s financial stability.
- It might be less or not effective while comparing companies withing different sectors/industries.
- While EPS is frequently used to assess a company's short-term profitability, it could lead people to prioritize short-term outcomes over long-term growth.
When it comes to stock investing, knowing a company's earnings per share (EPS) can be useful, but it's only one element of the whole picture.
Although earnings per share (EPS) is a widely used metric, it has several shortcomings that can sometimes mislead investors. Its fundamental shortcomings include its inability to capture long-term value, its vulnerability to accounting decisions, and its susceptibility to financial engineering. In addition, EPS often ignores important measures of financial health and fails to account for inflation, which can lead to an inappropriately positive assessment of a company's financial health.
Even though EPS can give investors a quick overview of profitability, they should go further and consider other metrics as well. This way, they could make better decisions by taking a comprehensive approach and grasping the subtleties behind these evaluations.
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Conclusion
Investors could determine whether a company's earnings are rising or falling over time by looking at its earnings per share (EPS). However, they should also carefully evaluate the industry and context.
Seasoned investors find a company's earnings per share (EPS) particularly relevant when they assess how the figures have evolved over time and how it stacks up against other businesses in the same sector. EPS should always be used together with other indicators as alone might not offer a complete picture.
Understanding EPS, how it is calculated and why it is important, could help investors make better informed investment decisions.
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Sources
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