Dec 1, 2022
What is Earnings Per Share (EPS)?
Earnings per share, or EPS, is an industry-standard ratio that indicates how profitable a company is on a per-share basis. Simply put, EPS shows how much money a company makes for each share of its stock. The EPS ratio is calculated by dividing the company’s profit by the outstanding shares of its common stock. Typically, when investors think a company has higher profits relative to its share price, they will pay more for shares. A higher EPS generally indicates a more profitable company and a better value for investors.
Stash these key points away for later:
- EPS shows how much profit a company earned per share of stock
- EPS is only one factor to consider when deciding on an investment
- Consider EPS in the context of P/E ratio and other profitability indicators
In this article, we’ll cover:
The importance of earnings per share
Determining whether it may be profitable to invest in a company’s stock is a core question for investors. Although it has its limitations, EPS can be a satisfactory indicator of a company’s profitability and cash flow now and in the future. The higher a company’s EPS, the more potential profit investors may expect to earn on their stock holdings.
It’s common practice for investors to consider EPS before investing in a company. Good EPS generally reflects both growth and acceleration over time, meaning shareholders may receive increased dividends. The SEC requires companies to submit EPS income reports quarterly and annually, making the information accessible and easy to track. And EPS is the only ratio that publicly traded companies are required to report.
That said, a single EPS value for one company won’t give you the full story. The number is more valuable when it’s measured against other companies in the same industry and compared to the company’s P/E Ratio.
EPS formula: how to calculate earnings per share
EPS equals the difference between net income and preferred dividends, divided by the average number of outstanding common shares. Net income is the money available to all shareholders after a company accounts for all costs and expenses. Preferred dividends refers to the cash dividends paid to preferred shareholders. Outstanding common shares refers to the number of common stock shares a company has issued to investors and company execs.
Earnings per share = (net income – preferred dividends)/avg. number of outstanding common shares
- Determine the company’s net income from the previous year
- Determine the number of common shares outstanding
- Divide the net income by the number of outstanding shares
Using the formula above, you can calculate the hypothetical EPS for shares of Apple. For this example, say that Apple’s net income for the past year totaled $99 billion, and preferred dividends totaled $10 billion. If outstanding common shares totaled $16 billion, EPS would equal $5.56.
$5.56 = ($99 billion – $10 billion)/$16 billion
Limitations of EPS
It’s important to remember that EPS is not a metric that should be used in isolation. There are limitations and drawbacks to relying on EPS alone: the numbers can be manipulated through the buyback of shares, unreported debt, inflation, and other factors. Things to keep in mind when you’re evaluating EPS include:
- Potential for manipulation: Organizations can manipulate EPS through stock splitting or the buyback of shares. When a company repurchases its own shares, it reduces the number of shares in issue, which automatically increases EPS.
- Debt: Because EPS doesn’t take into account a company’s debt, the earnings per share numbers could look good despite the potential negative impacts of a company’s debt on profitability and cash flow.
- Inflation: EPS doesn’t take inflation into account, so the numbers may be distorted. The P/E ratio is a better reflection of how inflation affects value. When inflation is high, P/E ratios are low; when inflation is low, P/E ratios are high.
- Financial leverage: Borrowing money to make an investment that will hopefully lead to greater returns is always a risk, and it can affect a company’s bottom line. A higher degree of financial leverage means a company’s EPS may be more volatile.
Basic earnings per share vs. diluted earnings per share
Basic EPS takes into account only common shares, while diluted EPS includes employee stock options, convertible securities, and secondary offerings. If exercised, these investments could increase the total number of shares outstanding in the market, thereby diluting EPS. Diluted EPS calculations are always lower than basic EPS, and many analysts consider them to be more accurate figures and predictors of profitability. To calculate diluted EPS, take the company’s net income minus preferred dividends, then divide the result by the sum of the weighted average number of shares outstanding and dilutive shares.
The bottom line: Look deeper than EPS
There’s no one way to determine what counts as a “good” EPS; it’s dependent on each company’s full financial picture and the market expectations. EPS may be the bottom line on the income statement, but it doesn’t provide a company’s full story on its own. When you’re making an investment decision, take the time to evaluate a company’s stock by tracking EPS over time and comparing it with other companies in the same industry. Remember that basic EPS can be manipulated, intentionally or not, through buyback and financial leverage. Use P/E ratio as an additional tool to assess the accuracy of EPS, and remember to consider the diluted EPS calculations for a clearer picture.
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