Earning Per Shares (EPS)

Earnings Per Share (EPS) is one of the most important financial ratios, and it can be used to develop the profit-earning capacity of the company on a per-share basis. This is arrived at using the following formula: Net income available to common shareholders divided by the weighted average number of shares. EPS is one of the measures that investors and analysts apply when investing in a particular company. It benchmarks the company and its efficiency against other companies in the industry.

In this article, the reader will gain more information about EPS, the significance of EPS in financial analysis, and how it impacts investment. In other words, to evaluate how much profit a firm generates and its solvency, one has to be familiar with what EPS is all about.

What is EPS?

Earnings Per Share (EPS) is a financial metric that shows how much profit a company makes for each outstanding common stock. It is obtained by applying the net income formula and the total number of shares.

Earnings per share is one of the factors that determines the company's profitability, and the higher the EPS, the better off the firm is seen to be by investors. EPS is one of the measures of industrial value, and it can be employed to measure the profitability of the companies in the industry.

How is EPS Calculated?

EPS is a financial measure that shows how much profit a company makes for each share. To calculate it, you divide the company’s net income by the total number of its common shares. Here’s a simple way to calculate EPS:

Earnings Per Share Formula = Net Income − Preferred Dividends / End-of-Period Common Shares Outstanding

EPS is a critical financial metric used to measure a company's profitability per share. Here's how it's calculated:

Example:

Let’s say a company has a net income of ₹10,00,000, preferred dividends of ₹50,000, and 1,00,000 weighted average shares outstanding.

{EPS} = ₹10,00,000 - ₹50,000/1,00,000 = ₹9,50,000/1,00,000 = ₹9.50

So, the EPS in this example would be ₹9.50.

What is the EPS Ratio?

The price-to-earnings (P/E) ratio, also known as the EPS ratio, measures the relative value of a company’s shares based on its earnings per share.

To calculate the P/E ratio, divide a company’s current market price by its EPS. This ratio helps compare a company’s valuation with its competitors, industry average, or historical data.

For example, if a company’s current market price is ₹100 and its EPS is ₹10, the price-earnings (P/E) ratio would be 10 (₹100 / ₹10). This indicates that investors might be willing to pay 10 times the company’s earnings per share for its stock.

Why is the EPS Ratio Important?

EPS is an important financial parameter for looking at the company's earnings. Here's why it's important:

1. Profitability Indicator

EPS is one of the simplest measures of a company’s profitability. It reveals how much earnings per share is assigned to each of the number of common stock. Higher EPS values imply better profitability and financial performance for the company, and this will attract investors.

2. Investment Valuation

EPS is an important factor used in the determination of the (P/E) ratio, which is popular in the valuation of organisations. A higher EPS can increase the P/E ratio, meaning that investors anticipate future growth to occur. On the other hand, lower EPS might be an indication of existing problems or lower growth expectations.

3. Dividend Decisions

Companies widely use EPS to calculate dividends they are willing to pay their shareholders. Higher EPS means that the company can pay more dividends to its investors, which is a key factor for income investors. It also symbolises the capacity of the company to make adequate profits to remunerate its owners.

4. Performance Comparison

EPS makes it easier to compare the financial performance of companies in the same industry. By expressing earnings on a per-share basis, investors will be in a position to compare which companies are better off in order to achieve diversification in their portfolios and investment strategies.

Types of EPS

EPS can be divided into several types, all offering different perspectives on the company's income statement. Some of the types of EPS are as follows:

1. Reported EPS or GAAP EPS

It is to be noted that this EPS is based on GAAP (Generally Accepted Accounting Principles). It encompasses all the items in the income statement, ranging from one-off gains or losses, thus providing a complete picture of the company’s profitability.

2. Ongoing EPS or Pro Forma EPS

The other type of EPS is the ongoing EPS, also referred to as the Pro Forma EPS, in which non-recurring or extraordinary items are excluded in order to provide a clearer picture of the company’s consistent profit-making ability. This type of EPS is used to analyse the sustainability of the earnings.

3. Retained EPS

Retained EPS is the part of the earnings per share retained by the company as it does not declare it as dividends. It shows the amount of money being ploughed back into the business to fund expansion.

Retained earnings are the profits a company keeps instead of distributing them to shareholders as dividends. These profits are added to the company's net earnings for the next accounting period to determine the total earnings for that period. Retained earnings are typically listed under the "stockholder's equity" section of a balance sheet.

Retained earnings per share (EPS) measures the portion of retained earnings that belongs to each share of the company's stock. It's calculated by adding the net earnings to the existing retained earnings, subtracting the total dividends paid, and then dividing the result by the total number of outstanding shares.

Formula:Retained EPS = (Net earnings + current retained earnings - dividends paid) / total outstanding shares

If the retained earnings are negative, they are subtracted from the net earnings of the following accounting period.

4. Cash EPS

Cash EPS is the measure of a company’s cash flow per share. It is arrived at by including other expenses that do not affect cash, such as depreciation and amortisation of the net income, in order to get a picture of cash profitability.

Cash EPS = Operating Cash Flow/Diluted Shares Outstanding

5. Book Value EPS

The Book Value EPS is derived from the book value, which is also the net asset value of the company on a share basis. It reveals the proportion of the ownership interest of the shareholders in the shareholders’ equity per share. It is used to establish the fair value of a stock.

Overview of The Different Types of EPS

Basic EPS Vs. Diluted EPS

Basic EPS and Diluted EPS are two of the most common measures used to assess a company's financial performance. Though both reflect earnings per share, they treat potential dilution arising out of convertible securities or stock options in different ways.

How is Basic vs Diluted EPS Calculated?

Basic EPS and Diluted EPS are two metrics used to assess a company's profitability on a per-share basis, with differing considerations for potential share dilution:

Basic EPS

Basic EPS is calculated by dividing the net income available to common shareholders by the weighted average number of common shares outstanding during the period.

Formula

Basic EPS = (Net Income – Preferred Dividend) / Common Shares Outstanding

Example

Net Income: ₹500,000

Preferred Dividends: ₹50,000

Weighted Average Shares Outstanding: 100,000

Basic EPS = ₹500,000 - ₹50,000/ 100,000 = ₹450,000/ 100,000 = ₹4.50

Diluted EPS

Diluted EPS takes into account all potential shares that could be created through conversions, options, warrants, and other convertible securities. It provides a more conservative view of EPS by considering the impact of these potential shares.

Formula

Diluted EPS = Total Outstanding Shares + Potential Dilutive Securities / Net Income

Example

Net Income: ₹500,000

Preferred Dividends: ₹50,000

Weighted Average Shares Outstanding: ₹100,000

Convertible Securities: ₹20,000

Diluted EPS = ₹500,000 - ₹50,000/ (₹100,000 + ₹20,000)  = ₹450,000/120,000 = ₹3.75

What are the Factors That Impact EPS?

EPS can depend on various factors. Some of the crucial factors by which you can impact the EPS are as follows:

1. Changes in Net Income

An increase in net income generally leads to a higher EPS, while a decrease in net income results in a lower EPS. Net income is a company's profit after all expenses and taxes have been deducted from total revenue.

2. Changes in the Number of Shares Outstanding

If the number of shares outstanding increases (for example, through issuing new shares), EPS may decrease because the same amount of earnings is spread over more shares. Conversely, if the number of shares decreases, EPS may increase.

3. Changes in Dividends

While dividends do not directly impact EPS, the decision to pay dividends can affect retained earnings and, consequently, net income. Higher dividends reduce the retained earnings available for reinvestment, potentially impacting future earnings.

4. Stock Buybacks

When a company buys back its shares, the number of outstanding shares decreases, which can lead to an increase in EPS. This is because the same amount of earnings is now distributed over fewer shares.

5. Changes in Accounting Policies

Changes in accounting policies or practices can affect how net income is calculated, impacting EPS. For example, changes in depreciation methods or revenue recognition policies can alter reported earnings.

What are the Limitations of EPS?

While a valuable profitability measure, EPS has limitations that can lead to misleading conclusions. Understanding these drawbacks is crucial for more informed financial analysis.

1. Can be Manipulated

Companies can manipulate EPS through various accounting practices. For example, they might buy back shares to reduce the number of outstanding shares, increasing EPS without improving profitability. Similarly, changing depreciation methods can alter reported earnings, giving a misleading picture of financial health.

2. Doesn’t Consider Inflation

EPS is calculated based on nominal earnings, which do not account for inflation. This means that over time, the real value of earnings can be distorted, especially in high-inflation environments. Investors might think a company performs better than it is when inflation is not considered.

3. Does Not Reflect the Quality of Earnings

EPS focuses solely on the quantity of earnings and does not differentiate between recurring earnings and one-time gains or losses. This can mislead investors about the company’s financial health, as a high EPS might be due to non-recurring events rather than sustainable business operations.

The Key Takeaway

Understanding EPS is vital for making informed investment decisions. It provides a clear picture of a company's profitability and performance, helping investors assess their investments' value and potential.

Regularly monitoring EPS trends can aid in predicting future performance and making strategic investment choices. By staying informed, investors can better navigate the complexities of the stock market and optimise their investment strategies.

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FAQs

Q1. What is a good EPS per share?

A good EPS indicates strong profitability and positive performance trends relative to the company's historical and future potential.

Q2. What does EPS tell you?

EPS reflects a company's profitability by showing the profit allocated to each outstanding share of common stock.

Q3. What is the EPS earned per share?

The company's net income is calculated by dividing EPS by the total outstanding shares.

Q4. Should I buy stocks with high EPS?

High EPS often signals a financially healthy company, which can be an excellent long-term investment.

Q5. What is a good P/E ratio?

A P/E ratio between 10 and 20 is generally considered reasonable. Ratios below 10 might suggest a bargain, while those above 20 could indicate a pricey stock.