The EPS calculation is done when a company’s profit is divided by the outstanding shares of its common stock. The earnings per share ratio serve as an indicator of a company’s profitability.
What is the earnings per share ratio?
Earnings per share (EPS) is the part of a company’s profit that a company allocates to each outstanding share of common stock. In other words, it is a market prospect ratio that measures the amount of net income that a company earns per share outstanding, that is the amount of money that each sharer of stock would receive if a company was to distribute profits to the outstanding shares at the end of the financial period.
Earnings per share, therefore, is a calculation that shows how profitable a company is on a shareholder basis. It is then possible to compare a larger company’s profits per share to a smaller company’s profit per share. It is obvious that the number of outstanding shares is an influencer in this calculation. With this, a larger company will have to split its earnings amongst many more shares of stock compared to a smaller company.
Single earnings per share value for a company is kind of arbitrary. This figure is more valuable when one analyzes it against other companies in the industry and when compared to the company’s P/E ratio. When making a comparison between two companies in the same industry with the same number of outstanding shares, a higher EPS is an indicator of better profitability.
EPS typically is used alongside a company’s share price to determine whether it is relatively cheap, that is low P/E ratio, or expensive, that is high P/E ratio.
Having looked at this explanation, we can say that EPS is an important financial metric that indicates the profitability of a company. It is a tool that participants in the market use on a frequent basis to gauge a company’s profitability before buying its shares.
In essence, it is of great importance to investors and people who trade in the stock market. As earlier stated, higher earnings per share of a company indicate that its profitability is better. While carrying out EPS calculation, it is advisable to make use of the weighted ratio because the number of shares outstanding is bound to change over time.
EPS is one of the several indicators that one could use to pick stocks. If one is interested in investing in stocks, the next step is to choose a broker that works for that investment style. Comparing EPS in absolute terms may not be so meaningful to investors because ordinary shareholders have no direct access to the earnings. Investors will rather compare EPS with the stock’s share price to determine the value of earnings and how investors feel about future growth.
EPS calculation, as earlier stated, is carried out as net income divided by available shares. The net income is also known as profits or earnings. A more refined EPS calculation adjusts the numerator and the denominator for shares that could be created through options, convertible debt, or warrants. The numerator of the equation also is more relevant if adjusted for continuous operations.
To carry out a company’s EPS calculation, the balance sheet and income statement are used to find the number of common shares at the end of the period, dividends paid on preferred stock if there are any, and the net income otherwise known as the earnings.
The EPS calculation becomes more accurate when a weighted average number of common stocks over the reporting term is used. This is because the number of shares outstanding can change over time as earlier stated.
Any stock dividends or splits that take place have to be reflected in the calculation of the weighted average number of shares outstanding. some data sources make the calculation simple by using the number of shares outstanding at the end of a period.
Earnings per share Formula
The earnings per share formula indicates how the company can produce net profits for common shareholders. The following formula can be used in carrying out EPS calculation;
EPS = (Net income – Preferred dividend) / Weighted average number of outstanding shares.
We have repeatedly stated that the number of outstanding shares may change over time, therefore, the weighted average is recommended in calculating earnings per share. The weighted average number of shares is the number of shares outstanding during the year weighted by the year they were outstanding. It is therefore necessary for analysts to find the equivalent number of whole shares outstanding for the year.
There are three steps to calculating the weighted average number of shares outstanding. Before taking these steps, first, identify the beginning balance of common stocks and changes in the common stocks during the year.
The steps are as follows;
- The first step is to compute the number of outstanding shares after each change that takes place in the common shares. The issuance of new shares brings about an increase in the number of shares outstanding. On the other hand, the repurchase of shares reduces the number of shares outstanding. Repurchased shares are known as treasury stock.
- The next step is to weigh shares outstanding by the portion of the year between this change and the next change that will take place. Weight is equal to days outstanding all over 365. It is also equal to months outstanding all over 12.
- The final step is, to sum up in order to compute the weighted average number of common shares outstanding.
EPS calculation and examples
For example, Emerald Inc. has a net income for the year-end 2017 of $450,000 and the preferred dividends paid in 2018 are $30,000. If at the beginning of the year 2018, the common shares outstanding were 50,000 shares, and then in the middle of the year, the company issued another 40,000 shares, what are the earnings per share of the company?
In this information given, the net income and the preferred dividends are known, that is the information needed for the numerator. However, we do not know the weighted average of common shares outstanding. Therefore, there is a need to calculate this from the data given.
In this case, before the EPS calculation, we have to calculate the weighted number of common shares outstanding first.
From the information above, the firm had 50,000 common shares from the beginning of the year, and in the middle of the year, 40,000 new common shares were issued. Now, we can consider 50,000 shares for the entire year while we consider 40,000 shares for the last six months.
The calculation will be;
Weighted average number of common shares = (50,000 x 1) + (40,000 x 0.5)
= 50,000 + 20,000
= 70,000 shares
We have found that the weighted average number of common shares is 70,000 new shares. Now, we can use the formula above to calculate the EPS for the company.
EPS = (Net income – Preferred dividend) / Weighted average number of outstanding shares
EPS = $450,000 – $30,000 / 70,000
EPS = $420,000 / 70,000
EPS = $6 per share
Effect of stock dividends and stock splits on EPS
In calculating the weighted average number of shares, stock dividends and stock split only change in the units of measurement, not changes in the ownership of earnings.
When a stock dividend or stock split occurs, the computation of the weighted average number of shares will require a restatement of the shares outstanding before the stock dividend or split. Therefore, it is not weighted by the portion of the year after the stock dividend or split.
Specifically, before carrying out the three steps of computing the weighted average, there are numbers that are restated to reflect the effects of the stock dividend or splits such as the opening balance of the shares outstanding and all share issuance or purchase before the stock dividend or split.
No restatement is made for shares issued or purchased after the date of the stock dividend or split. In the occurrence of a stock dividend or split at the end of the year before the issuance of the financial statements, it is compulsory for the weighted average number of shares outstanding as well as any other years presented in the comparative form to be restated.
Why earnings per share is important
- It helps in comparing the performance of promising companies which in turn helps investors to pick the most suitable investment option.
- The figure of earnings per share can also be used to compare a company’s financial standing over the years. Companies that have a steady increase in EPS can be a reliable option for investment. On the other hand, seasoned investors do not prefer companies that have irregular EPS.
- As earlier pointed out, a higher EPS is an indicator of more profitability which suggests that the company is likely to increase dividend payout over time,
- Aside from helping to measure a company’s current financial standing, EPS helps to track its past performances.
When it comes to measuring the financial standing of a company and its profitability, the above points indicate the importance of earnings per share.
- Although EPS is seen as a powerful financial tool, one of its drawbacks is that most business owners tend to manipulate it to project the venture as frequently profitable. However, most of these attempts are made for the short-term which oftentimes hampers the image of the business and its profitability in the long run.
- Oftentimes, cash flow is not considered in EPS calculation and this implies that a high EPS may not accurately represent the company’s financial health. Of course, it is factual that cash flow is an important gauge of a company’s ability to repay its debt.
- The fact the EPS is calculated using net income is a limitation. Non-cash expenses such as depreciation and amortization are subtracted from net income and also, and capital expenditures are lumpy in nature. This can cause the net income of a company to vary greatly across reporting periods. Businesses can have non-operating expenses such as tax and interest payments that are much different, this affects net income. Therefore, a company’s net income is not an accurate reflection of its cash flow or the health of its business.
- Usually, the earnings per share ratio is useful when it is evaluated with other metrics such as the P/E ratio which compares the stock price of a company to its EPS, and the return on equity (ROE), which indicates the amount of profit a company generates from its net assets.
Is a high EPS ratio good?
A high EPS indicates that the company is profitable and this attracts investors. With this, we can say that a high EPS ratio is good.
Is a higher or lower EPS ratio better?
Although the earnings per share ratio has its limitations, a company should have a higher EPS ratio. This is why some business owners tend to manipulate their earnings per share ratio. Every investor is attracted to a company that has a higher earnings-per-share ratio because it indicates that the company is profitable.