Earnings per share (EPS) is one of the fundamental financial metrics used in the share market to evaluate a company’s financial performance. EPS can indicate the amount of profit a company generates per share of its outstanding common stock. This article will provide an overview of EPS, its calculation method, and its significance in the share market. Additionally, it will explore some of the limitations of EPS and highlight other financial metrics that investors should consider when evaluating a company’s financial health.
What are Earnings Per Share?
Earnings per share or EPS is defined as the share of a company’s profit distributed to each one of the shares. Further, it is considered a significant financial parameter as it helps gauge a company’s financial health. It is widely used by investors, analysts, and other market participants to assess a company’s growth potential, risk profile, and overall value Simply, higher EPS reflects more profitability from the company and all of its ventures. Let’s dive deep into what EPS is and how it works.
Earnings Per Share (EPS) Formula
There are many ways to calculate earnings per share (EPS). We’ve provided below the two versions of the EPS formula:
1) EPS = (Net Income Minus Preferred Dividends) / End of period Shares Outstanding
2) EPS = (Net Income Minus Preferred Dividends) / Weighted Average Shares Outstanding
The 1st formula uses total outstanding shares to calculate EPS, but in practice, analysts can use the weighted average number of shares outstanding when calculating the denominator. Since outstanding shares can change with time, analysts often use last-period outstanding shares.
Another variant of EPS formula is adjusted EPS. This removes all non-core profits and losses and those in minority interests. Here, the focus of calculation is to check only profit or loss sourced from core operations on a normalized basis.
Use of EPS by Investors and Share Market Analysts
EPS as a metric has the ability to serve as an indicator for a company’s current and future prospects (financial). It’s a portion of a company’s net income allocated to each outstanding common share.
Investors and analysts typically use EPS to gauge a company’s financial strength. In fact, it is alternatively known as the bottom line. Here a firm’s worth is concerned, literally, as the last item on the income statement as well as figuratively.
A higher EPS implies that a company is generating enough revenue to pay out more money to its shareholders. For instance, a company might increase its dividends as earnings increase gradually. Investors generally compare the EPS of two or more competitor companies to understand how one company performs compared to its peers.
They may also look for trends in a company’s EPS growth over time to better understand how profitable a company has been, how the earnings have grown, and the potential for future performance. A company with a constantly increasing EPS figure is considered a more dependable investment than one whose EPS is on the decline or varies substantially.
Overview of the Different Types of EPS:
The table provided below will brief you on various types of EPS:
|S. No.||EPS Variations||Calculations|
|1.||Reported EPS or GAAP EPS||Calculated as per Generally Accepted Accounting Principles.|
|2.||Ongoing EPS or Pro Forma EPS||This does not include a subject’s unusual one-time income in the total net income.|
|3.||Retained EPS||The summation of net earnings and current retained earnings is subtracted from divided pay. The outcome is divided by the total outstanding shares.|
|4.||Cash EPS||Total operating cash is divided by outstanding diluted shares.|
|5.||Book Value EPS||Take the current balance sheet into account to compute the EPS.|
Effect of Stock Dividends & Stock Splits on EPS
While calculating the weighted average number of shares, stock dividends, and stock splits are only changed in the units of measurement, not converting the ownership pattern of earnings. A stock dividend or split shareholders).
When a stock dividend or split occurs, the computation of the weighted average of shares requires the restatement of the shares outstanding before the stock dividend or split.
Hence, it is not weighted by the year’s portion post the stock dividend or split.
But, prior to starting the 3 steps of computing the weighted average, the following numbers are reiterated to reflect the effects of the stock split or dividend:
The starting balance of shares outstanding;
- All share issuance or purchase before the stock dividend or split;
- No restatement is made for shares issued or purchased after the date of the stock dividend or a split.
If a stock dividend or a split happens post the end of the given year but prior to the issuance of financial statements, the average of shares outstanding for the year and any other years presented must be restated.
How Earnings Per Share Affects Stock Valuation?
Earning represents the company’s profitability and is considered the most critical indicator of the company’s financial health. The public listed companies report earnings 4 times a year, and we note that market analysts and investors closely follow this earnings season. Growing earnings, or EPS, is a measure of a company’s outstanding performance and, in a way, a measure of returns for the investor.
EPS is direct to the stock markets by the wide-tracked Wall Street PE Multiple or Price/EPS ratios. The lower the PE multiple relative to the Industry average PE, the better it is for investments as well as valuations. Stock prices react strongly to quarterly earnings because of the same connection.
Importance of Earnings Per Share
The following pointers give key takeaways on importance of earnings per share is when it comes to gauging a company’s revenue generating and financial capabilities:
- It helps gauge if your investment in a company can help investors generate more income. A higher EPS is generally an indication of a profitable status. This suggests that the company may increase dividend payout over time.
- Also, it helps compare the performance of promising companies to help pick the most suitable investment option.
- Similarly, with the help of EPS investors and other financial methods, one can determine a company’s existing and anticipated stock value. Further, it helps in analyzing if its stock price is valued according to its market performance. For instance, investors use the Price Earnings Ratio and the Price Earnings Ratio to measure the same. In the Price earnings formula (P/E), ‘E’ stands for earnings, computed with the EPS formula’s help.
- EPS not only helps measure a company’s current financial standing but also helps track its past performances. For instance, a company with a steadily increasing EPS is often considered a reliable investment option. Likewise, seasoned investors usually do not prefer companies with faltering or irregular EPS.
Limitations of Earnings Per Share (EPS)
Although earnings per share are considered a potent financial tool, they must remember that EPS has its drawbacks.
The list below highlights a few of its limitations which both the investors and business owners must remember:
- Most business owners tend to manipulate the EPS frequently to project their venture as a profitable one. However, most such attempts are made for the short term, which often hampers a business venture’s image and profitability in the long run.
- Since EPS does not consider inflation, its growth may not be precise in the first place. For instance, inflation increases the overall price of goods and services. This, in turn, indicates a misleading EPS value if the venture fails to buy or sell more goods compared to what it did in the past year.
- Cash flow is vital to gauging a company’s ability to repay its debt. However, cash flow is not factored in EPS calculation, meaning a high EPS may still prove ineffective for gauging a company’s solvency.
Hence, before figuring out the merit of a company as an investment option, investors should make sure to check other important factors as well. In fact, they should align EPS with other financial parameters to gain a fair idea of a business venture’s scope, profitability, and market performance.
EPS and Price-to-Earnings (P/E)
Comparing the P/E ratio among industry peers can be of help, though in unanticipated ways. Though, it seems like a stock that’s valued more compared to its EPS when compared to peers can be “overvalued,” often the opposite tends to be the rule. Regardless of its historical EPS, investors are ready to pay more for a stock if it is forecasted to grow or to outperform its peers. In a bull market, it is standard for the stocks with the highest P/E ratios in a stock index to outperform the other stocks in the index.
What Is a Good EPS?
What is meant by a good EPS will depend on various factors such as the recent performance of the company, the performance of its peers, and the expectations of the stock analysts who follow the stock. Sometimes, a company might report growing EPS, but the stock might decline in price if analysts were expecting an even higher number.
Similarly, a shrinking EPS figure could lead to a price increase if stock analysts were expecting an even worse result. It is important to always judge EPS in relation to the company’s share price, such as by looking at the company’s earnings yield or P/E.
Difference Between Basic EPS and Diluted EPS
Analysts often distinguish between basic and diluted EPS. Basic EPS consists of the company’s net income divided by its outstanding shares. It is the figure most commonly reported by the financial media and is also the simplest definition of EPS.
Diluted EPS, on the other hand, will always be lower than or equal to basic EPS because it includes a more expansive definition of the company’s outstanding shares. Specifically, it includes shares that are not currently outstanding but could become outstanding if stock options and other convertible securities are exercised.
The Bottom Line!
EPS is a crucial financial metric used in the share market to evaluate a company’s profitability and financial performance. While EPS can provide important insights into a company’s financial health, it should be used parallel to other financial indicators and not relied upon in isolation. By considering a range of financial indicators and exercising caution, investors can make more informed and profitable investment decisions in the share market.