Earnings per share, or EPS, is a common metric used to assess corporate value. Here’s what you need to know in order to calculate earnings per share.
What is earnings per share?
Earnings per share indicates a company’s profitability by showing just how much money a business makes for each share of its stock. The EPS figure is determined by dividing the company’s net profit by its outstanding shares of common stock. However, earnings per share can be adjusted for share dilution or extraordinary items, which we’ll explore below. Generally, the higher the EPS number, the more profitable the company.
Earnings per share explanation
The EPS is usually reported on a quarterly or annual basis. To calculate earnings per share, the company’s income statement and balance sheet are used to find net income, dividends paid on preferred stock, and end number of common shares. Most companies use a weighted average number of common shares for the reporting term for greater accuracy. However, to simplify this, you could also use the number of outstanding shares at the end of the reporting period.
Earnings per share formula
With those figures in hand, you can plug them into the earnings per share formula:
Earnings Per Share = (Net Income – Dividends) / Average Number of Shares Outstanding
Here’s what that might look like in practice.
Company A has a net income of $10 million for the quarter and pays out $2 million in dividends to its stockholders. It has an average of 5 million shares outstanding during the quarter. Use these figures to calculate earnings per share:
($10 million net profit – $2 million dividends) / 5 million shares = $1.6 per share.
Therefore, the earnings per share is $1.60.
Diluted earnings per share explanation
The formula above tabulates all the company’s outstanding common shares into the equation. A diluted earnings per share formula goes one step further by considering all convertible securities. This would apply when a company might have convertible preferred stock options that might become common stock at some point. This would increase the number of shares, thus reducing the earnings per share. As a result, a diluted EPS will always be lower than the basic EPS.
For example, if you take Company A from above and add 1 million convertible preferred shares to the equation, the new diluted EPS would be $1.33 ($8 million / 6 million shares).
EPS and extraordinary items
Another way the EPS can stray from its basic formula is to exclude ‘extraordinary items.’ These are lucky breaks or one-off events that create a windfall or reduction in profit for the company but won’t likely be repeated in the next financial term. Examples could include a land sale producing a large chunk of profit. Once that land has been sold, the transaction can’t be repeated. Another example would be a factory fire, which would lead to a sudden, unusual loss.
When it comes to profits and losses of this nature, including these extraordinary items in the EPS equation would paint an inaccurate picture for investors. As a result, the profit or loss should be excluded from the formula’s net profit.
Why is earnings per share significant?
With greater earnings come higher stock prices, which leads to more money for investors. As investors look at company stock options, the EPS is an indicator of potential profit. Companies with a higher earnings per share have more money to distribute to stockholders via dividends. The funds could also be used to reinvest and grow the business. In either case, it’s a good indicator of potential profit.
What are the limitations of earnings per share?
A high earnings per share number marks a worthwhile investment, but it doesn’t paint a full picture of financial health. Companies can inflate the EPS by buying back their own shares, thus reducing the number of shares outstanding for investors. This would improve the EPS without increasing profits. The EPS metric also doesn’t take every factor into account, like cash flow, outstanding debt, or liabilities. This is why it’s crucial for investors to conduct their own research, looking at the bigger financial picture of a company.
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