EPS (earnings per share) is an important unit of measurement for investors to gauge a company’s profitability. It indicates a company’s profitability against its peers on a per-share basis. One can calculate EPS on a quarterly or annual basis by dividing a company’s net income by its total number of outstanding shares.
Now, let’s dive into the meaning of EPS, its formula, and its uses.
What Are the Earnings per Share (EPS) of a Company?
EPS is a financial ratio of a company’s profits to the total number of outstanding shares available during a certain period. Before calculating EPS, one must subtract a company’s preferred dividends from its net income. This net income is left after subtracting all cash and non-cash expenses.
All companies report their earnings per share in every quarterly and annual income statement. It indicates how much revenue a company makes for each share. Market participants regularly use this value to compare two companies before buying equity shares.
Between two companies with the same number of outstanding shares, the one with higher EPS is more profitable. Investors often compare the EPS of companies with their PE ratio to see if they are relatively expensive (higher P/E ratio) or cheaper (lower P/E ratio). PE ratio refers to the relationship between a company’s stock price and its EPS value.
What Is the Earnings per Share (EPS) Formula?
Earnings per share are calculated as net income divided by the total number of available shares. EPS indicates a company’s ability to produce earnings or profits for common shareholders over a fixed period.
To calculate a company’s EPS, one can use one of the following two methods:
- Earnings per share = Net income after tax / total number of outstanding shares
- Weighted earnings per share = Net income after tax – Preferred dividends / Weighted average of outstanding shares
Investors use the weighted average of outstanding shares to monitor the cost basis (purchase price) of shares over a period. The weighted ratio is more accurate as the total number of shares outstanding can change over time. It also considers stock dividends or splits in the stock’s history.
However, some data sources simplify the calculation by using the number of shares outstanding at the end of a certain period.
Calculation of EPS with Example
The following examples will illustrate how to calculate EPS using the above formula.
A. ABC Pvt Ltd is a company that reported a net income of Rs. 70 lakh in a year. By the year’s end, its total number of shares outstanding is 1,00,000. The company has not issued any preferential share capital.
Therefore, the EPS of ABC Pvt Ltd would be:
EPS = Rs. 70,00,000 / 1,00,000 = Rs. 70 per equity share
B. XYZ Traders is a company with a net income of Rs. 5 crores at the end of the 2nd quarter. The company has announced dividends worth Rs. 50,00,000 and its total shares outstanding is 1,20,00,000.
The earnings per share for XYZ Traders would be:
EPS = Rs. 5,00,00,000 – 50,00,000 / 1,20,00,000 = Rs. 3.75 per share
How Can Investors Use EPS to Compare Stocks?
Investors interested in a steady source of income may want to look at the EPS ratio to see if a company has room to increase its current dividend distribution. However, one should not look at a company’s EPS alone to make an investment decision. This metric is more valuable when one compares it to industry standards, total shares outstanding, and the P/E (price to earnings) ratio of other companies.A higher earnings per share usually indicates a better chance of a company to produce higher net profit and value for shareholders. However, there are some drawbacks to making investment decisions based on a company’s EPS.
For example, a company can inflate its EPS by buying back stocks or reducing the number of shares outstanding.
EPS also does not take into account the share prices and thus, cannot be used to know if a particular stock is overvalued or undervalued. Therefore, investors usually use other metrics such as price/earnings ratio and return on equity (ROE) to determine how much profit a company makes.
ROE is a measure of a company’s efficiency and profitability. It is the company’s net income divided by shareholders’ equity. The PE ratio gives a better sense of a company’s value for investors than its share price.
Investors can also compare a company’s capital with their earnings per share to identify more efficient companies. Let us take the example of two companies — A and B. Both have the same EPS, but B uses fewer assets. All things being equal, B would be a more efficient company in terms of efficiency.
Basic EPS & Diluted EPS: What’s the Difference?
Basic EPS is the simplest definition of EPS and is calculated as a company’s net income divided by its outstanding shares. On the other hand, diluted EPS include a more expansive definition of a company’s outstanding shares. It includes convertible securities such as convertible bonds, preference shares, stock options, and warrants.
Diluted EPS is computed by deducting preferred dividends from net income and dividing the amount by the sum of the weighted average of outstanding shares and diluted shares.
Let us say that ABC Pvt Ltd has 1,00,000 outstanding shares, 50,000 employee stock options, and 30,000 preference shares that can be convertible to common shares. Therefore, its diluted EPS can be computed in this manner:
Diluted EPS = Rs. 70,00,000 / (1,00,000 + 50,000 + 30,000) = Rs. 38.89 per share (approx.)
Diluted EPS is always less than the basic EPS of a company. It is a more accurate calculation that takes into account convertible securities, which a company can use to dilute its EPS. For large companies with more potential for dilution, this EPS is more meaningful.
Final Word
Investors use earnings per share (EPS) to track a company’s performance and make investment decisions. Investors interested in particular shares, this value indicates the company’s room to increase existing dividends. Companies also publish their diluted EPS and EPS after the exclusion of extraordinary items so that investors make a more informed decision.