Earning Per Share (EPS)

Earning Per Share (EPS) is a widely used financial metric that is essential for investors when evaluating a company’s financial health. It is an indicator of how much profit a company has earned in relation to its outstanding shares of stock. In this article, we will discuss the importance of EPS, how it is calculated, and its limitations.

What is Earning Per Share?

EPS is a financial ratio that measures the number of earnings generated by a company per outstanding share of its common stock. In other terms, it’s how much of the company’s earnings are distributed to each share of common stock. EPS is considered a fundamental metric that helps investors determine a company’s profitability and growth potential.

How Are Earnings Per Share Calculated?

Earnings per share (EPS) is determined by dividing a company’s net revenue by its outstanding shares of ordinary stock.

The formula for EPS is as follows:

EPS= (Net Income – Preferred Dividends) / Weighted Average Shares Outstanding

Where:

• Net Income: The total amount of profit earned by the company after deducting all expenses, taxes, and interest payments.
• Preferred Dividends: The total amount of dividends paid to preferred stockholders.
• Average Outstanding Shares: The average number of outstanding shares of common stock during the accounting period.

The earnings per share (EPS) of a business can be determined in the following way, using the following assumptions: the company has a net income of $10 million, has paid dividends of $1 million to preferred stockholders, and has an average of 5 million shares of common stock outstanding during the accounting period.

EPS = ($10 million – $1 million) / 5 million shares

EPS = $1.80 per share

This means that the company’s net income is $1.80 per share of common stock outstanding, and investors can use this information to evaluate the company’s profitability and make informed investment decisions.

Types of EPS

EPS can be broken down into two categories: Basic EPS and Diluted EPS.

• Basic EPS: This is the most commonly reported type of EPS, and it represents the net income available to each outstanding share of common stock. To determine basic EPS, divide the net income by the number of shares of common stock outstanding for the time.
• Diluted EPS: Diluted EPS takes into account the potential impact of securities that could be converted into common shares, such as stock options, convertible preferred stock, and convertible debt. It assumes that these securities have been converted into common stock, which could increase the number of outstanding shares and reduce the EPS. Diluted EPS is calculated by adjusting the number of outstanding shares in the denominator by the number of potential additional shares that would be created if the securities were converted into common stock. Both basic EPS and diluted EPS are important indicators of a company’s profitability and financial health, and investors use them to evaluate a company’s earnings potential and make informed investment decisions. Companies are required to report both types of EPS in their financial statements to provide a complete picture of their financial performance.

Benefits of Earning Per Share (EPS) for Investors and Companies

• The measure of profitability: EPS is a key measure of a company’s profitability, and it provides investors with valuable information about a company’s financial health. Higher EPS indicates that a company is earning more profits per share, which can make it more attractive to investors.
• Comparison between companies: EPS can be used to compare the profitability of different companies in the same industry. Investors can compare the EPS of one company to another company to determine which one is more profitable and which one is a better investment.
• The basis for dividends: EPS is also used by companies as a basis for determining dividends to be paid to shareholders. Companies may pay dividends to shareholders based on their earnings per share, and higher EPS means that a company has more earnings to distribute as dividends.
• Stock valuation: EPS is an important factor in determining the value of a company’s stock. The higher the EPS, the higher the value of the company’s stock, all other things being equal. EPS is used by investors to estimate the future value of a stock and to make investment decisions.
• Financial reporting: EPS is required to be reported by publicly traded companies in their financial statements. This helps to ensure transparency and provides investors with accurate information about a company’s financial performance.

Limitations of EPS

Earnings per share (EPS) is a financial indicator used to compare the success of different companies by dividing their net income by the total number of shares in circulation. Even though earnings per share (EPS) is a crucial measure, it does have some drawbacks that investors should be aware of.

1. EPS does not consider the quality of earnings: EPS does not differentiate between sustainable earnings and one-time gains or losses. Companies can manipulate EPS by using accounting methods such as aggressive revenue recognition, which can artificially inflate EPS.
2. EPS does not consider the size of the company: EPS can be misleading when comparing companies of different sizes. A larger company may have a lower EPS than a smaller company, even if it is more profitable in absolute terms.
3. EPS does not consider the cash flow: EPS is based on net income, which is an accounting measure. It does not take into account the company’s cash flow, which is a more accurate measure of a company’s financial health.
4. EPS does not consider the dividends paid: EPS does not take into account the dividends paid to shareholders. A company with a high EPS but a low dividend payout may not be as attractive to investors as a company with a lower EPS but a higher dividend payout.
5. EPS does not consider the debt: EPS does not take into account the debt of the company. A company with a high EPS may be using debt to finance its operations, which could be risky in the long run.