Earnings Per Share (EPS) – Everything Investors Need to Know

What is Earnings Per Share or EPS?

To calculate earnings per share (EPS), you need to divide a company’s profits by its common stock’s total outstanding shares. The result offers general insight into the company’s profitability. 

In simple words, EPS means how much money a company makes for each share and is primarily used for estimating corporate value. increasing EPS implies the company is becoming more profitable and vice versa.

EPS Formula

Here’s how you can calculate the EPS:

Let’s take an example – A company, ABC, reports a net income of $12M and announces $2M in preferred dividends for its fiscal Q1. During the period, the company had 5M (weighted average) outstanding shares.

The EPS of the ABC company as per the formula mentioned above would be
EPS = $ (12M – 2M) / 5M = $2

It is advisable to use a weighted average number of outstanding common stock over the reporting term as the actual number of shares can vary over time.

Understanding EPS

The EPS metric is one of the most significant variables in shaping a stock price. It is also an important component used for calculating the price to earnings (P/E) valuation ratio. In the P/E ratio, the E stands for EPS. By dividing a company’s stock price by its EPS, you can calculate the share value in terms of how much the market can afford to pay for each earned dollar.

It is essential to judge EPS with respect to the company’s stock price, P/E ratio, or earning’s yield. A low EPS number compared to the last quarter might still lead to a surge in share price if analysts were expecting a worse figure.

Significance of Earnings Per Share

  1. EPS helps investors understand whether investing in a particular company is profitable. A consistent EPS growth may indicate the company’s profitability, suggesting its ability to pay higher dividends over time.
  2. EPS is an input in the P/E ratio, that can help you compare the performance of promising companies and select the most suitable option.
  3. Earnings per share can help you understand the company’s present financial standing and track its historical performance. For example, a company with a consistently rising EPS is often considered a safe investment option. Similarly, companies with declining or irregular EPS are typically not preferred by regular investors.

Limitations of Earnings Per Share

Although EPS is a useful financial tool, it still has limitations. Some of them are:

  • Companies may manipulate EPS through stock buyback etc to show profitability. While most of these attempts are short-term, it may hamper the company’s reputation and profitability in the long-term.
  • EPS does not account for the debt that the company holds. It thus gives only a partial picture of the company’s financial position.
  • EPS calculation also doesn’t factor in cash flow, which is a critical aspect for gauging a company’s debt repaying ability. Hence, EPS might prove ineffective for evaluating the company’s solvency.

Before selecting any stock for investment, you should also consider other factors such as company stability, relative strength in the industry, debt to equity ratio, and P/E ratio, among others. If the EPS aligns with these factors, you will have a clearer idea of its market performance, profitability, and overall scope.

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