In investing, while picking up stocks, investors generally prefer fundamental analysis of a company by evaluating their financial stability and profit generations. One of the most popular and effective metrics to identify the earning potential of different companies is EarningsPer Share, also known as EPS. Earnings Per Share becomes necessary to understand in detail to generate the best returns for your investment.
What is Earnings Per Share?
Earnings Per Share (EPS) can be defined as the profit per share that is to be distributed to each shareholder of stocks. It’s an important and direct statistic to reflect and measure the profitability of a company.In other words, this amount is the portion of a company’s profit that is allocated to every individual holding a share of stock in a particular financial year.It is calculated by dividing the company’s net income earned per share of stock outstanding. The higher a company’s EPS, the higher is its profitability and vice versa.
How to calculate EPS?
Here’s how you can calculate the EPS with the help of a formula-
EPS = (Net Income – Preferred dividends)/Weighted average number of common shares outstanding
Let’s explain this with the help of an example, where a company’s net income for the year 2020 is Rs. 10 billion, dividend announced is Rs.1 billion over the year, and their 20 billion shares are outstanding.
Therefore, the EPS of that company as per the formula would be –
Weighted Earning Per Share = (10 billion – 1 billion) / 20 billion
EPS = Rs 0.45
Impact of Earnings Per Share
EPS is very significant as it directly indicates the profitability of the company. A company can boost its EPS by increasing its earnings or reducing its share count through share buybacks, whereas a company that increases its outstanding share count faster than its earnings will cause its EPS to drop.
However, a large company’s profit per share cannot be compared to a small company’s profit per share. A larger company will have to split its earnings amongst many more shares or stockholder compared to a smaller company.
Types of Earnings Per Share:
There are several types of EPSs that companies report or disclose but these 5 types of EPS can be used to make an informed investment decision:
Popularly known as the reported EPS, it is based on the Generally Accepted Accounting Principles (GAAP). For example, the income gain from the sale of machinery can be treated as operating income under GAAP and cause EPS to spike.
It’s calculated based upon an ongoing net income and excludes a large one-time gain from the sale of equipment as well as an unusual expense. This type of EPS is important to use as a basis for future EPSs.
Pro Forma EPS:
The words “pro-forma” indicate that assumptions are used to derive whatever number is being discussed. Different from reporting EPS, Pro Forma EPS generally excludes some expenses/income that was used in calculating the reported earnings.
As the name suggests, Headline EPS is the EPS number that is reported by the company itself in its press release. Headline EPS can be the pro-forma EPS or the one calculated by some analyst who is analyzing that company.
It is derived by dividing operating cash flow by the number of outstanding diluted shares. Cash EPS gives a better understanding of the financial status of a company because operating cash flow cannot be manipulated as easily as net income and represents real cash earned, calculated by including changes in the key asset categories such as receivables and inventories.
Importance of Earnings Per Share
The following factors highlight how important EPS is when it comes to measuring a company’s profitability and financial standing:
Higher the EPS, Higher the Payout
A higher EPS of the company means a higher payout to you as a shareholder.
Compare companies in the same industry
Comparing the EPS of companies within the same industry helps you to evaluate how a company performs relative to others.
A better understanding of the company’s future prospects
A consistently increasing EPS helps to forecast the future profitability of a company than a company with a declining or inconsistent trend.
Determine the fair value of stock price
With the help of EPS, investors can determine a company’s existing and anticipated stock value. You can determine if the company is expensive or fair-valued compared to similar companies in its industry.
Limitations of Earnings Per Share
Although EPS is a potential performance analyzing tool, it comes with its limitations and drawbacks-
- The management can manipulate the EPS by projecting their firm as a profitable one. However, such attempts last for a short period, often hampering the business image and profitability in near future.
- EPS doesn’t count on cash flow. If cash flow is not factored in EPS calculation, that means a high EPS might prove ineffective in estimating a company’s solvency.
- It also ignores inflation. The price of goods and services might be increasing generally, which could contribute to the good EPS figure. However, this growth might be misleading if the company can’t continue buying as many good this as they did the previous year.
- Every company has different accounting policies and it’s tough to compare companies individually on like for like basis.
How to calculate non-diluted EPS?
The Non-diluted EPS can be calculated by using the formula,
Non-diluted EPS= Net Income/Current Shares Outstanding
How to calculate diluted EPS?
The diluted EPS can be calculated by using the following formula.
Diluted EPS = Net Income/Current Shares Outstanding +Exercisable Rights on New Shares
What are the components of an EPS equation?
EPS equation comprises the following components.
- Net Income
- Exercisable Rights on New Shares
- Current Shares Outstanding
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