The primary purpose of any investment is the returns or gains earned over time. For equity investments, returns may be in dividends or capital appreciation. Dividend refers to the distribution of the company's earnings to its shareholders, whereas capital appreciation is the difference between the investment's purchase cost and market value.
Analysts use financial ratios to analyze investment worth, the company's financial health, and peer review. Earnings per share or EPS is one such commonly used financial ratio. EPS divides the net earnings available to equity shareholders in a financial year by the outstanding equity shares. EPS is a measure of the company's return for each of its shareholders. It is directly proportional to profitability. A higher EPS signifies greater value since investors are willing to invest more in a company's shares if it has higher profits than its share price.
The earnings per share meaning and importance are detailed below.
What are Earnings per Share?
EPS or earnings per share is one of the most important factors to consider for equity investments. An absolute comparison of EPS may not be meaningful because retail investors may need direct access to the company's current earnings. Thus, analysts prefer to compare EPS with the current market price to determine the value of earnings and prospects. Similarly, EPS is more useful when evaluated with other companies in the same industry.
There are various methods to evaluate EPS, such as earnings not including extraordinary items, discontinued operations, or diluted EPS. Typically, the financial statements of a company include basic or diluted EPS.
How is EPS calculated?
1. Basic EPS
The EPS formula for earnings per share calculation is as below –
EPS = (Net Income – Preferred Dividend) / Common Shares Outstanding
Net income refers to profits or earnings during a financial period. Earnings per share are more accurate if the net income adjusts for income from discontinued operations and extraordinary items. Common share outstanding represents the total equity shares outstanding at the end of a financial period. Alternatively, some analysts prefer to use weighted average shares outstanding.
For example, the net income of ABC Ltd. is Rs. 10 Lakhs. The company pays a preferred dividend of Rs. 2 Lakhs. The average number of shares outstanding for the current period is 8 Lakh.
Therefore, the EPS = (Rs. 10 Lakhs – Rs. 2 Lakhs) / 8 Lakh = Re. 1 per share.
2. Diluted EPS
Diluted earnings per share is a more advanced EPS calculation and accommodate potential shares that may arise from warrants, convertible debt, or options. Diluted EPS assumes the company issues all potential shares it may create.
In the above example, ABC Ltd. issues convertible debentures that may lead to the issue of 2 Lakhs equity shares in the future. Thus, the potential number of shares outstanding will be 10 Lakhs.
Therefore, the diluted EPS = (Rs. 10 Lakhs – Rs. 2 Lakhs) / 10 Lakh = Rs. 0.80 per share.
Similarly, an adjustment to the numerator is necessary to calculate the diluted EPS. The shares from the potential conversion of debentures are in the denominator of the diluted EPS calculation. On conversion, the company is not liable to pay interest on the debt. Thus, the company or analyst will increase the numerator by the interest paid on convertible debt.
Types of Earnings Per Share
EPS is an important financial parameter that directly impacts investment decisions. Analysts tend to evaluate a marginally different aspect of the ratio to derive a company's stock valuation. The broad categories of EPS are as follows:
● Trailing EPS – Trailing EPS considers the financial numbers of the previous year. It focuses on past performance and is not futuristic. Trailing EPS assumes that the company's past performance will continue in the future.
● Current EPS – As the name suggests, the current EPS is a function of the current income and projections. It gives a realistic view of the present case scenario. It ignores prospects or growth plans.
● Forward EPS – Forward EPS factors anticipated future projections and estimates. It is more forward-looking and does not factor in past performance. Therefore, forward EPS is subject to variables and may change with time.
Each category of EPS has variations in calculating the EPS amount. These include the following:
1. Reported EPS
Reported EPS refers to the earnings per share presented in the financial statements and other statutory compliances. Companies align reported EPS with generally accepted accounting practices (GAAP). However, reported EPS may be selectively accurate. Also, each industry or company has different reporting requirements.
For example, a company may classify income from a one-time machinery sale as income from operations. In this case, the reported EPS will not accurately illustrate the company's earnings. Similarly, if a company treats a recurring expense as unusual, it can artificially inflate the reported EPS.
2. Proforma EPS
Proforma EPS or ongoing earnings per share exclusively considers ordinary net income. It excludes any revenue that may be one-time. The objective is to identify the income earned from the core business activities. Proforma EPS excludes revenue from investment activities or extraordinary sources.
Proforma EPS involves certain assumptions to exclude non-core revenue items. For example, it excludes some income or expense used to compute the reported EPS. Therefore, some investors believe it needs to project the company's real earnings.
3. Retained EPS
Retaining earnings refers to the revenue set aside by the company rather than distributing it to shareholders as dividends. Companies hold on to retained earnings to pay off any existing debt, business expansion, or unforeseen circumstances.
Generally, companies add retained earnings for a given period to the net income for the subsequent financial period. Thus, retained earnings help arrive at the period's aggregate earnings. Companies report retained earnings under shareholder's equity in the balance sheet. Conversely, if the retained earnings are negative, the company reduces it from the net income of the following year.
The formula for retained EPS is as below:
Retained EPS = (Net income + current retained earnings – dividend paid) / number of outstanding shares.
4. Cash EPS
The concept of cash EPS is slightly different. While the other EPS focuses on revenue, cash EPS emphasizes cash earned. It helps to gain perspective about the company's financial standing. It is difficult to manipulate cash EPS. Depreciation accrued income and expenses and profit or loss from revaluation of assets are some of the non-cash items.
Cash EPS = Operating Cash Flow / Diluted Shares Outstanding
5. Book Value EPS
Book value or carry value EPS considers the current balance sheet values to compute the EPS. It enables analysts to compute the aggregate value of the company's assets for each equity share. Book value EPS is also useful for calculating a company's net worth for liquidation.
However, it is a static illustration of the company's performance since it concentrates on the value of assets and liabilities on a particular date.
Importance of Earnings Per Share
EPS measures profitability and financial standing. In addition, it is also useful for the following reasons:
i. Returns on Investment
EPS help gauge a company's current and future income generation capacity. A company with a high EPS indicates higher profitability than its peers. Consequently, it suggests that the company may increase dividend payouts. Thus, it may lead to a better return on investment.
ii. Peer Review
Analysts compare the EPS of similar companies in an industry to identify the most suitable investment alternative. It also provides insights into a company's future earnings potential compared to its peers. In a stable EPS, an investor may reshuffle holdings to a different company in the same industry.
iii. Investment Decisions
Investors use EPS for buy, sell, or hold decisions. Analysts use EPS and the price-earnings ratio to determine a security's existing or anticipated value. It helps to identify the intrinsic value of an equity share. Also, a comparison between a security's intrinsic and market value helps identify over or under-valuation. The investor may purchase a security in case of undervaluation or sell it if overvalued.
iv. Past Performance
EPS is also useful when tracking the past performances of an entity. A company with a steady increase in EPS is a reliable investment option. Contrarily, experienced investors avoid a company with a faltering or decreasing EPS.
Limitations of Earnings Per Share
As discussed, EPS is a useful financial tool. Although it is subject to certain limitations, these include the following:
a) EPS Manipulation
The accuracy of EPS is a cause for concern to investors. Companies may manipulate the EPS with inflated revenue or deflated costs. Businesses may attempt to project short-term profitability, but it impacts the goodwill and financial stability of the company in the long term.
One of the most important limitations of EPS is that it does not consider the impact of inflation. Therefore, the growth indicated by it may need to be revised. For example, the goods and services cost increases with inflation. It projects a misleading EPS value if the business fails to increase the turnover compared to the previous financial year.
c) Cash Flow
Cash flow is an important factor in gauging a company's short-term liquidity and debt repayment capacity. However, EPS calculation does not factor in any cash flow. Thus, EPS needs to estimate the company's solvency effectively. For example, a company with a serious liquidity crisis but a high EPS may give investors a false representation, and the company may appear to be profitable.
In conclusion, investors, the company's management, and analysts regularly review EPS to ensure the company is on the right track. However, EPS is not a sufficient measure. Thus, one must analyze the company's EPS and other financial parameters to assess overall investment scope, profitability, and market performance.
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Frequently Asked Questions
Non-diluted EPS is the net income divided by the weighted average outstanding equity shares.
Diluted EPS is the adjusted net income divided by the adjusted total weighted average equity shares. Diluted EPS accommodates current shares and exercisable rights for potential shares.
Net income, current outstanding shares, and exercisable rights of potential shares are the components of an EPS equation.