What is Earnings Per Share (EPS)?

Introduction

As an investor, you must conduct due diligence before investing in any company's stock. You can do this by evaluating the earnings per share in the company's recent quarterly reports.

In essence, earnings per share (EPS) reflects a company's profitability and provides information about the profit earned per share of outstanding stock in a given period. This quick guide will explain what is EPS in stock market, how it works, and how you can use it to make investment decisions.
 

What is Earnings Per Share (EPS)?

Earnings per share (EPS) is determined by dividing the net earnings available to the shareholders by the average outstanding shares. The EPS formula is used to determine a company's ability to generate profits for its shareholders. In this guide, we break down the Earnings per Share meaning and formula in detail.

EPS values are somewhat arbitrary for a single company. The number is more valuable than other companies within the same industry, and to the company's stock price (the P/E Ratio). When two companies have the same number of shares outstanding but have varying EPS, higher EPS indicates higher profitability. A company's earnings per share are typically compared with its share price to determine how cheap or expensive it is (low or high P/E ratio).
 

Formula and Calculation for EPS

Now that we know what is EPS in the share market, let’s learn how it's calculated.

The following are two formulas for determining EPS:

EPS = (Net Income –  Preferred Dividends) / Shares Outstanding at the end of the period

and 

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

EPS is calculated using the total number of outstanding shares, but analysts often use the weighted average number of outstanding shares when calculating the denominator. Companies may issue stock throughout the year and this makes it difficult to determine the true outstanding shares and earnings per share. Therefore, we commonly use an average number. By measuring average outstanding shares, you can accurately determine a company's earnings.
 

Example of EPS

Having learned the earnings per share definition and formula, consider the following scenario for calculating earnings per share (EPS) for three companies:

How Is EPS Used?

EPS has multiple purposes, including

●    EPS helps investors determine whether investing in a company would increase their income. In other words, a higher EPS indicates a more profitable company, which may lead to a higher dividend payout.
●    Additionally, EPS can compare the performance of promising companies to make an informed investment decision.
●    Additionally, EPS investors and other financial methods are useful for estimating a company's stock value, both now and in the future. Additionally, it evaluates if the company's market performance determines the stock price. As an example, investors measure this based on the Price Earnings Ratio. EPS is used to calculate earnings (E) in the Price earnings formula (P/E).
●    The EPS of a company is not only used to measure the company's current financial situation but also to track its past performance. It is often considered reliable to invest in companies whose earnings per share are steadily increasing. A seasoned investor usually does not favour companies with faltering or irregular earnings per share.
 

Diluted EPS vs. Basic EPS

There are similarities between basic and diluted earnings per share (EPS), but they are different concepts. Divide a company's profit or income by the number of outstanding shares to calculate basic EPS. In calculating diluted earnings per share, we consider all possible dilutions, such as when convertible securities are exercised or options are converted into shares.

We should use the diluted earnings per share method when valuing a company if the company is expected to undergo significant dilution due to employee stock options or similar actions. Other than that, basic earnings per share are sufficient for estimating future cash flows.

The following hypothetical example illustrates how basic EPS differs from diluted EPS when calculating investor value. We will use the scenario where someone owns one share of Company X, which had a net profit of Rs. 1 crore in its first year and did not need any additional debt or equity financing.

Assume that there are 100 shares outstanding and that the price per share is Rs. 10. Let's ignore dividends and taxes for simplicity's sake. In year 2, 50 employees get stock options at Rs. 5 per share. Moreover, 10 shares of employee stock were purchased for Rs. 7 each to reduce risk by diversifying among all employees. Net income increased by 10% due to these actions, while all 110 potential shares were diluted by 5%. In this case, you will get Rs.0.91 per share instead of Rs.0.95 if you divide earnings by basic EPS rather than diluted EPS.

As an investor, both types of earnings per share are useful because they provide different perspectives on the value of a company based on the outlook for the future.
 

EPS Excluding Extraordinary Items

Several factors can distort earnings per share, either intentionally or unintentionally. EPS is calculated using a variety of basic formulas to avoid the most common inflated methods.

Consider a company with two factories manufacturing cellphone screens. Over the past few years, new developments have surrounded the land where one of the factories sits, increasing its value. The company's management team decides to sell the factory and build a new one on less valuable land. Firms gain windfall profits from this transaction.

Although the company and its shareholders have made real profits from this land sale, it is considered an "extraordinary item" since the company cannot necessarily repeat that transaction in the future. The windfall may mislead shareholders, so it is excluded from the EPS equation numerator.

For the same reason, if a company suffered an unusual loss - perhaps the factory burned down - which temporarily reduced EPS, the loss must be excluded from EPS.
 

What is a good EPS?

Various factors, including the company's recent performance, competitors, and analysts' expectations following the stock, determine a good EPS.EPS may increase, but a company's stock price may decline if analysts expect even higher earnings.

If analysts were anticipating an even worse result, a shrinking EPS number might still result in a price increase. A company's EPS should always be judged by its share price, including its P/E ratio and earnings yield.
 

Conclusion

A company's EPS represents its profitability and can be used to determine a stock's price with its earnings. The higher the earnings per share, the better, but one must also take into account the number of shares outstanding, dilution possibilities, and earnings trends over time. Shares of a company can either crash or rally if its EPS falls below or exceeds analysts' consensus expectations.