If you’re an investor or trader, a company’s Earnings Per Share, otherwise abbreviated as EPS is a crucial parameter to your investment or trading decisions. EPS is considered one of the most important indicators of whether or not a company is worth trading or investing in. Here’s what you need to know about EPS:
EPS Definition: What Is Earnings Per Share (EPS)?
A company’s EPS or Earnings Per Share gauges a company’s profitability and is calculated by dividing the company’s net profit by the number of shares outstanding. As such, higher EPS can mean higher profitability. That is to say that EPS refers to how much money a company makes per share which then is used as a general indicator of a company’s value.
Types of EPS
There are main types of EPS; Basic EPS and Diluted EPS whereby the latter reflects a company's earnings per share more accurately if convertible securities are exercised, as it takes into account the potential dilution of earnings.
As the name entails, a basic EPS is the simplest form of EPS and is a company’s total amount of net income for each common share outstanding.
Diluted EPS is lower than a basic EPS as it measures how well a company's earnings per share (EPS) would have performed if all convertible securities were exercised. Convertible securities refer to stocks, bonds, and stock options that can be converted into common shares and allow traders or investors to buy them at any time at a set price.
How Is EPS Used?
EPS is a multifaceted economic metric and can be used for a myriad of purposes by different individuals depending on their goals. For example, investors and traders can refer to it in order to understand a company’s value. They can use it as a comparison between companies so as to make more weighted trading and investing decisions. Analysts can use it to assess companies' growth potential and analyze their performance. Companies, on the other hand, may use their EPS to report their financial performance to their shareholders and investors. (Source:Investopedia)
How to Calculate EPS: Earnings Per Share Formula
While there are multiple ways to calculate a company’s Earnings Per Share, a company’s Basic Earnings Per Share (EPS) is calculated by dividing its net income per outstanding share of common stock. Once expenses and costs are deducted from a company's income, net income becomes available to all shareholders. The basic EPS calculation formula goes as follows:
Basic EPS = (Net Income - Preferred Dividends) / (Weighted Average of Common Shares Outstanding)
In other words, divide a company's profits by its outstanding shares of common stock.
Average outstanding shares are used in the formula due to stock issues and stock buybacks throughout the year, which make it difficult to pin down the actual outstanding shares and earnings per share. Accordingly, it becomes possible to provide an accurate picture of earnings based on a company's outstanding shares by averaging them.
The formula for Diluted EPS is calculated as such:
Diluted EPS= (Net Income - Preferred Stock Dividends)/ (Average Outstanding Shares + Dilutive Shares)
Additionally, when calculating diluted EPS, future shares that a company might issue are included.
What Is an Adjusted EPS?
As a type of EPS calculation, an Adjusted EPS is calculated by adding or subtracting components of net income that are deemed to be nonrecurring from the numerator of the calculation. Typically, it refers to the numerator of the calculation that the analyst has adjusted.
Furthermore, nonrecurring components can include discontinued operations losses, stock-based compensation expenses, or one-time charges. Take for example if a company had a certain one-time operation that increased its shares, an analyst may choose to exclude this component from the company’s net income when calculating its EPS.
Limitations of EPS
EPS can be useful for investors and traders to understand their investments better by measuring a company's performance, but it also has its limitations. EPS can often be subjective if mistreated by the company issuing them.
This is because in order to show profitability, companies can manipulate EPS through stock buybacks, increasing their EPS, or reducing their number of outstanding shares. However, it is important to keep in mind that while most of these attempts are short-term, they could be detrimental to a company's long-term reputation and profitability.
Another possible drawback of EPS is that EPS excludes a company’s debt and cash flow which could mean that it does not show its overall profitability and financial stability.
EPS can also be affected by changes in accounting policy and the fact that a company's share price is not taken into account by EPS, which makes it harder to determine if the stock is overvalued or undervalued.
Does EPS Mean the Same Thing as Dividends?
EPS and dividends are not the same things. The Dividend Per Share refers to the number of earnings returned to shareholders by the company's board. Usually, dividends are paid as cash payments. Earnings Per Share, on the other hand, reflects the earnings (net income) of the company per share.
What Is a “Good” EPS Ratio?
While there’s no one-size-fits-all approach to EPS rates since companies with lower EPS can also end up performing well, generally speaking, an EPS of 80 or more is considered good. This is because this level of EPS is often considered an indicator of more success for the stock in question.
Is a High EPS Ratio Good?
Higher EPS usually indicates higher profitability which may be deemed as good. Nonetheless, traders should bear in mind that EPS can sometimes be manipulated by the companies and does not necessarily reflect their profitability in the best way possible. As such, higher GDP does not always means better performance.
Knowing a company’s EPS, how it works, and how it’s calculated is a crucial step toward understanding your trading strategy or investment portfolio better. However, despite the fact that EPS is deemed a good overall indicator of a company’s profitability, being aware of its possible drawbacks and limitations is as important to your overall trading.