Earnings Per Share (EPS)

What Is Earnings Per Share?

Earnings Per Share (EPS) is a financial metric representing the portion of a company's profit allocated to each outstanding share of common stock. So, how to calculate EPS? It is calculated by dividing the company's net income (after taxes and preferred stock dividends) by the average number of outstanding shares over a specific period, usually a quarter or a year.

EPS is crucial for investors as it indicates a company's profitability on a per-share basis. It is often used to evaluate a company's performance and compare it with peers in the same industry. A higher EPS generally suggests better financial health and potential returns for shareholders.

Let us understand the Equation of Earnings per share

Let us break down the earnings per share (EPS) calculation formula for ABC Company (ABC Company is an example):

ABC Company has a net income of Rs. 20 lakh. They also need to pay Rs. 4 lakh as preferred dividends. There are 5 lakh common shares outstanding during the current period.

How is EPS Calculated - EPS Formula

To find the EPS, use the below formula  

EPS = (Net Income - Preferred Dividends) / Weighted Average Number of Common Shares

So, for ABC Company:

EPS = (20, 00,000 - 4, 00,000) / 4, 00,000

EPS = Rs. 4 per share

Here is a simpler explanation:

EPS shows a company's profit for each outstanding share of common stock. For ABC Company, after subtracting the preferred dividends from their net income, the EPS is Rs. 4 per share.

Calculating EPS using the weighted average number of common shares is important because the number of shares can change over time. This gives a more accurate picture of earnings per share.

Understanding EPS is crucial for investors as it helps gauge a company's profitability and performance relative to its stock price.

The use of EPS in the stock market

Earnings per share (EPS) is a crucial metric for understanding how profitable a company is for each outstanding share. It is also key in calculating the price-to-earnings (P/E) ratio, which shows how much investors are willing to pay per rupee of earnings.

Investors use EPS to gauge a stock's value and potential growth. They compare EPS to the stock's price to assess if it is a good investment. However, EPS on its own does not tell the full story because shareholders do not directly receive these earnings. Instead, it helps investors understand the company's profitability and how the market perceives its prospects.

Difference Between Basic EPS vs. Diluted EPS

Basic EPS (Earnings Per Share) and Diluted EPS are two important metrics used to measure a company's profitability and performance. Here are the key differences between Basic EPS and Diluted EPS:

Basic EPS:

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

                                                       Net Income attributable to common shareholders
            Formula: Basic EPS =    _________________________________________

                                                       Weighted Average Number of Common Shares Outstanding

Scope: Basic EPS gives a straightforward measure of the company's earnings per outstanding share of common stock without considering the potential impact of dilutive securities.

Diluted EPS:

Calculation: Diluted EPS takes into account the potential dilution from all dilutive securities such as stock options, convertible preferred stock, or convertible bonds. These securities have the potential to increase the number of outstanding shares if converted to common shares.

Formula: Diluted EPS is typically calculated by adjusting the denominator of the Basic EPS formula to include the potential shares that could be issued upon conversion of dilutive securities.

Purpose: Diluted EPS provides a more conservative measure of earnings per share by assuming that all potential dilutive securities are converted into common shares.

Difference in Numerators for Basic & Direct EPS

The numerator (net income attributable to common shareholders) is the same for both Basic EPS and Diluted EPS calculations.

Difference in Denominators for Basic & Direct EPS:

The denominator for Basic EPS includes only the weighted average number of common shares outstanding.

The denominator for Diluted EPS includes the weighted average number of common shares outstanding plus the potential additional shares from dilutive securities if they were converted to common shares.

Impact of Dilution

Diluted EPS is generally lower than Basic EPS because it considers the potential impact of dilutive securities, which could increase the number of shares outstanding.

Reporting Requirements

Companies are required to report both Basic EPS and Diluted EPS in their financial statements to provide investors with a clear picture of earnings per share under different scenarios (basic and fully diluted).

EPS from Continuing Operations

Imagine a company that started the year with 600 stores and made ₹ 6.00 per share. During the year, they closed 100 stores and ended up with 500 stores by the year-end. Now, an analyst wants to figure out how much the company earned per share just from those 500 stores that are still open. This helps the analyst observe how well the remaining stores are performing without the impact of the stores that are closed, which might have been losing money.

5 Types of Earnings Per Share

There are different types of EPS, each indicating different aspects of this financial measure. Depending on which EPS is used, it can show whether a company's stock is considered undervalued or overvalued.

Generally, EPS is divided into 3 broad categories, such as – 

• Trailing EPS: Refers to the company's earnings per share calculated over the past twelve months.
• Current EPS: Refers to the earnings per share based on the company's most recent financial year or quarter.
• Forward EPS: Refers to the estimated earnings per share that analysts predict a company will attain in future fiscal periods.

Let us go through the 5 types of earnings per share

Reported EPS or GAAP EPS

This type of EPS follows standard accounting rules known as Generally Accepted Accounting Principles (GAAP) and is reported in official filings with the SEC. However, GAAP can sometimes make a company's earnings look different. For example, if a one-time payment is counted as regular income according to GAAP, it might make EPS seem higher than it is. Likewise, if normal expenses are labelled as unusual, it can also make EPS appear higher than usual.

Ongoing EPS or Pro Forma EPS

This type of EPS is calculated using regular net income and does not include income that is usually considered unusual or one-time. It helps show expected earnings from the main business activities but might not show the company's complete earnings accurately.

Retained EPS

Retained EPS shows that a company keeps its profits instead of paying them out as dividends to shareholders. Business owners use retained earnings per share to pay off debts, grow the company, or save money for future use. To find it, you add the current year's profits to what is already saved, subtract any dividends paid, and divide the result by the total number of shares in the company.

Cash EPS

Cash EPS shows how much cash a company has earned, giving a clear view of its financial health. It's hard to change artificially and is found by dividing Operating Cash Flow by the number of diluted shares in the company.

Book Value EPS

This type of EPS calculates how much each share of a company's stock would be worth if the company were to be sold and its assets distributed to shareholders. It shows a fixed view of the company's performance because it looks at the balance sheet.

Different types of EPS give different insights into how well a company is doing financially. They are helpful for investors who want to understand different aspects of a company's earnings and financial health.

EPS and Capital

One key part of EPS that is often overlooked is how much capital a company needs to earn through income. Two companies might have the same EPS, but one could achieve this with fewer assets. This shows that the company is better at using its capital to make money, and all else being equal, it would be considered a more efficient company. A measure used to find such efficient companies is the return on equity (ROE). 

EPS and Dividends

Even though EPS is commonly used to measure how well a company is doing, shareholders do not directly receive these profits. Some of the earnings might be given to shareholders as dividends, but the company can also keep some or all of the EPS for itself. Shareholders would need to work through their representatives on the board of directors to decide how much of the EPS should be paid out as dividends if they want access to more of those profits.

EPS and Price-to-Earnings (P/E)

Comparing the P/E ratio among companies in the same industry can be useful, but it can lead to unexpected conclusions. While a stock may seem expensive relative to its earnings compared to others, it often indicates that investors believe it will grow or perform better than its peers. During a strong market, stocks with higher P/E ratios in an index typically outperform those with lower ratios.

Top 6 limitations of Earnings Per Share (EPS)

While earnings per share is a powerful financial measure, however, it is important to remember that it also has some limitations such as:

• EPS does not account for non-cash items such as depreciation and amortization, which can affect a company's true financial health.
• EPS does not consider a company's debt or capital structure, which can affect its financial stability and risk profile.
• EPS may not be comparable across different companies or industries due to varying accounting methods and capital structures.
• It emphasizes short-term results over long-term sustainability and growth potential.
• EPS can be influenced by market factors such as changes in interest rates or investor sentiment, which may not reflect the company's operational performance.
• It may not provide a comprehensive picture for valuation purposes, especially when used in isolation without considering other financial metrics. 

Understanding these limitations helps investors and analysts use EPS more effectively alongside other financial measures to evaluate a company's performance and prospects.