Earnings per share (EPS) is a key metric used to evaluate a company’s profitability on a per-share basis.  EPS indicates profitability for per ordinary share over the company reporting period and is disclosed in its financial statements – usually on the same page as the Income Statement.

EPS provides insights into a company’s financial health and is often used to make investment decisions – by comparing the earning per share to the price per share, and the flipside of this: the price to earning ratio (P/E).

It is also used by equity investors as a key indicator of profitability (not cash!) accruing to their investment.

 

What is EPS?

EPS measures the portion of a company’s net income that is allocated to each outstanding share of common stock (ordinary share capital). It is calculated by taking net income and dividing by the weighted average number of shares outstanding. (‘weighted average” is only relevant if the company has issued / bought back shares during the reporting period)

  • Net income is the profit after interest, tax: right at the bottom of the P&L. Also called equity earnings, net profit, or simply profit after interest and tax.
  • Shares outstanding refer to the total number of shares held by all shareholders, including restricted shares, but not treasury stock. Companies often have different classes of shares like common stock and preferred stock. EPS focuses on ordinary shares.
  • Note that ‘outstanding’ shares will exclude shares issued but held by the company on its own behalf (‘treasury shares’ or ‘treasury stock’). The reason for that exclusion is that Treasury Shares are essentially ‘warehoused’ shares waiting to be transferred to external investors.   They do represent invested capital. In fact, the opposite is true! – they arise on the balance sheet when the company returns capital to investors (a share buyback).

 

EPS provides insights into a company’s financial health and is often used to make investment decisions – by comparing the earning per share to the price per share, and the flipside of this: the price to earnings ratio (P/E).

It is also used by equity investors as a key indicator of profitability (not cash!) accruing to their investment.

 

Formula for Earnings Per Share

In its simplest form, it is calculated by dividing net income by the weighted average number of shares outstanding.

The basic formula for EPS is:

EPS = (Net Income – Dividends on Preferred Stock) / Weighted Average Number of Common Shares Outstanding

 

Where:

  • Net Income: Net profit after taxes for a company over a period
  • Preferred Dividends: Any dividends paid out to preferred shareholders
  • Weighted Average Common Shares: The number of shares outstanding across the period, adjusting for changes in shares outstanding over time

 

Companies may have complex capital structures with multiple classes of stock, but the formula above can be used to calculate basic EPS.

 

Basic EPS vs Diluted EPS

There are two primary types of EPS metrics – basic and diluted.

  • Basic EPS uses just common shares outstanding in the denominator. This represents the minimum EPS figure.
  • Diluted EPS adjusts for the impacts of securities that could potentially dilute (reduce) EPS if converted to common shares. This includes things like stock options, warrants, convertible debt, etc.

Diluted EPS provides a more comprehensive view of how EPS could change due to the conversion of all dilutive securities. Diluted EPS will always be equal to or lower than basic EPS. Companies are required to report both basic and diluted EPS on financial statements.

 

 

Interpreting EPS in Valuation

EPS is useful for valuation in several ways:

  • Assessing profitability: Higher EPS indicates greater net income and return for shareholders. EPS trends over time show profit growth. But you cannot compare one company EPS to another, since the number of shares issued by a company is somewhat arbitrary.
  • Price-earnings ratio: The P/E ratio uses EPS in the denominator. P/E indicates the current share price relative to EPS and can therefore be thought of as “how many years it would take to earn back your investment, if earnings don’t change”. Earnings do change however, so don’t think of this out of context.
    • A high P/E ratio indicates one of two things: either price is too high or earnings too low. For example, a P/E for a tech company might be 80x – does this mean investors would wait 80 years to earn back their investment? No, it is an indicator that investors / markets expect growth. The higher the growth expectation, the higher the P/E.
  • Growth rates: EPS growth year-on-year indicates improving profitability. Comparing EPS growth to revenue growth provides insight into performance.
  • Dividend payout ratio: Dividends per share divided by EPS shows the percentage of EPS paid as dividends. And the flipside ratio is Dividend Cover – Earnings / Dividends. Higher coverage indicates the capacity to sustain dividends.

 

However, as EPS is dependent on the number of shares issued by the company, it is not appropriate to compare EPS of one company to another.

E.g.       Company 1:    Net income $100m, No. of shares: 100m   So EPS is $1

Company 2: Net income $50m, No. of shares: 25m. So, EPS is 50m/25m = $2.

Company 2 is not more profitable, but each share an investor owns has earned them a higher return. The missing piece of the jigsaw here is, well, what did the investors pay for their shares?

Additionally, EPS should also not be viewed in isolation as it does not account for capital structure, or leverage. Additionally, leverage can significantly distort equity returns volatility, and the EPS doesn’t show this.

 

 

Exercises and Examples for Earnings Per Share

Let’s run through some exercises and examples to practice calculating EPS:

 

Example 1 – Basic EPS

Net income: $250,000

Preferred dividends: $5,000

Weighted average common shares outstanding: 100,000

 

EPS = ($250,000 – $5,000) / 100,000 = $2.45

 

Example 2 – EPS growth

Net income in Year 1: $500,000

Net income in Year 2: $750,000

Number of shares outstanding:

 

Year 1: 200,000

Year 2: 225,000

Year 1 EPS = $500,000 / 200,000 = $2.50

Year 2 EPS = $750,000 / 225,000 = $3.33

 

This shows an increase in EPS from $2.50 to $3.33, driven by growth in net income.

 

Example 3 – Basic vs diluted EPS

Net income: $1,500,000

Preferred dividends: $75,000

Common shares outstanding: 600,000

Stock options representing 100,000 common shares

 

Basic EPS = ($1,500,000 – $75,000) / 600,000 = $2.38

Diluted EPS = ($1,500,000 – $75,000) / (600,000 + 100,000) = $2.04

 

The stock options decrease diluted EPS compared to basic EPS.

 

In summary, EPS is a useful metric to evaluate profit generation per share but remember: profits do not equal cash!

Earnings per share is calculated by dividing net income less preferred dividends by the weighted average common shares outstanding. Comparing basic EPS to diluted EPS, accounting for potentially dilutive securities, provides comprehensive insights. When used alongside other metrics and additional considerations like tax implications and sector-specific norms, EPS helps investors assess company performance and make investment decisions.