A company’s earnings per share (EPS) can help investors understand how much money a company earns for each of its common shareholders. Investors can use analogy to better understand a company’s performance relative to its competitors and industry. And it is an important contribution to other economic measurements.
What is Earnings Per Share (EPS)?
A company’s EPS shows you how much money the company made for each common stock. “A higher EPS indicates better financial health, greater value and more dividends to shareholders,” said AnnaMarie Mock, a wealth consultant at Highland Financial Advisors, LLC.
The EPS ratio is usually calculated for each quarter and year and you generally do not want to look at an EPS ratio individually. Instead, think of these as actions that you must take on a regular basis to compare with the EPS of similar companies.
Why is EPS important?
A company’s EPS can be important when deciding whether to sell, hold or buy a company’s stock. You can use it for:
- Understand the profitability of a company, which can affect its dividends and share price.
- Calculate the price to profit ratio of the company (P / E ratio), which measures the share price in relation to its EPS.
- See if the company’s profits increase or decrease over time.
- Compare the real EPS of the company with the expectations of analysts.
- Compare the company EPS with the EPS of direct competitors.
But there is no number that represents a “good” EPS – it’s all about.
“EPS can be very different from one industry to another, so a good EPS depends on the company and expectations for future performance,” says Mock. “It is better to compare EPS for similar companies, as the interpretation may be subjective otherwise.”
How to calculate EPS
The basic EPS calculation is quite simple, although many variations can lead to different results.
First, subtract the company’s net income (ie net profit) from preferred dividend payments for a given period – usually a quarter or year. Eliminate preferred dividends because EPS displays earnings only for common stock.
Then divide the result by the weighted average number of shares outstanding during the period. Sometimes, the number of outstanding shares at the end of a period is used. However, a weighted average may be more useful because companies usually issue or buy shares.
The EPS type
For example, consider Company X, which earned $ 750,000 in net income and paid $ 80,000 in preferred dividends in the previous year. The numerator is $ 750,000 – $ 80,000 = $ 670,000.
Company X had 200,000 outstanding shares for the first six months of the year and 250,000 outstanding shares in the second half of the year. The average weighted shares outstanding are 225,000.
The basic EPS is $ 670,000 / 250,000 = $ 2.98
You can find the relevant numbers in the quarterly and annual reports of public companies. Alternatively, you can simply search for the company’s EPS in the income statement.
Basic EPS vs. diluted EPS
There are several EPS calculations that investors may want to use when researching a company. Two common ones are basic EPS (what is described above) and diluted EPS.
“Unlike the basic formula, this includes convertible securities, such as preferred stock and stock options that can be ‘converted’ to common stock at any time,” Mock explains. “Because there is the possibility of including more securities as common stock, the total number of outstanding shares increases and, in turn, decreases the EPS.”
Public companies are required to indicate both their basic and diluted EPS, as appropriate, in their public records.
What EPS can not tell you
Knowing a company’s EPS can be helpful when investing, but it is only one piece of the puzzle.
First, EPS does not take into account the current share price. Maybe the company is doing well, but the price is so high that it is currently overpriced and a bad investment.
Basic and diluted EPS calculations also overlook how an extraordinary income or expense has affected the company’s finances.
For example, a company may make a large one-off sale that leads to a high EPS for a quarter or a year. However, if the company cannot resume the sale, the increased profits are not sustainable. A customized or normalized EPS calculation will show the company’s EPS after removing one-off events and seasonal changes from a company’s earnings.
Even if you look at EPS trends, you need to dig deeper to understand why a company’s EPS is rising or falling.
EPS can be reduced as a company increases its R&D costs – which is not necessarily a bad long-term move. High-tech and drug-intensive research companies may have negative EPS, but they could offer good inventory growth opportunities. On the other hand, the increase in EPS may also be due to a variety of changes, such as increased sales, repurchases of shares and reduced costs.
The financial package
EPS can help you understand if a company’s profits are increasing or decreasing over time. But you want to understand the context and the industry.
“Examining EPS alone does not provide the whole picture,” says Mock. “There are many factors to consider when reviewing a potential investment, including future inflation forecasts, interest rates and the market climate.”
You should not ignore the EPS of a company – especially in relation to its previous performance and its competitors. Instead, think of these as actions that you must take on a regular basis to make the most of your investment decisions.