One of the key concepts in any stock market investment journey is earnings per share or EPS. It is the net income that is earned for every share, if all profit was to be distributed among shares of a stock.
Earnings per share is calculated with the help of a formula, called the EPS formula. The earnings per share calculation is as follows:
EPS = Net income – preferred dividends / outstanding common shares
id in case a company goes bankrupt. Also, when it comes to dividends in general, preferred shareholders get fixed and regular dividends while common shareholders may not.
From the EPS formula above, you can surmise that preferred dividends have been subtracted from net income. The reason for this is that EPS is a measure of income that is available to the common stockholder. The preferred dividends are kept apart for preferred shareholders. Preferred holders are those who are risk-averse and get prioritised over common shareholders when dividends have to be.
Example of earnings per share formula
So, if a company had a net income of Rs 20 billion and stock dividends preferred are Rs 2 billion, and outstanding common shares were at 10 billion. The company’s earnings would be Rs 20 billion – Rs 2 billion = 18 billion. Applying the earnings per share formula to this, the company would have an EPS of Rs 18 billion / 10 billion = Rs 1.8.
Diluted earnings per share
There is also another calculation called the diluted earnings per share. This diluted EPS formula is as follows:
Diluted EPS = Net income – dividends on preferred stocks/average outstanding shares + diluted shares.
The diluted EPS factors in securities that are convertible. These securities may include preferred shares or options, for example. Diluted shares are the overall shares a company owns at a specific point that could be converted into regular shares. When these are converted into shares, the company’s earnings per share comes down.
While EPS takes into account only common shares of a company diluted EPS considers all convertible securities.
Types of EPS
Having learnt the earnings per share calculation, the next step would be to get an idea of the types of earnings per share. Some of them are:
Ongoing EPS: The ongoing earnings per share calculation is made by taking into account the net income that is current and discounts one-off events. The purpose of this type of EPS is to understand a company’s earnings via its core business. This helps in gauging income in the future.
Adjusted EPS: This is also called the ‘headline’ earnings per share and shows profits or losses that have come through the operations that are not at the ‘core’ of the business.
GAAP or reported EPS: Here, the earnings per share formula applied is based on principles of accounting also called GAAP (generally accepted accounting principles).
Trailing EPS: This is an earnings per share calculation wherein the earlier year’s number is taken into account. The trailing EPS uses the earnings of the earlier four quarters and uses real numbers rather than projections.
Significance of earnings per share
– Earnings per share is important because it indicates whether a company’s finances are in good shape.
– Typically, traders use EPS to judge a company’s health. They also compare the EPS of two firms in the same sector/industry. A high EPS would mean the firm is profitable to a measure and is capable of paying out more to shareholders.
– Earnings per share helps an investor understand not just the financial position of a company at the current time but also monitor its past performance. If a company has consistently shown a growing EPS, it is indicative of an appropriate investment possibility. If companies show EPS that is dropping or inconsistent over a period of time, they may not be a choice by investors.
– Earnings per share is also a key variable when it comes to computing the value of a stock. EPS comes into the picture when the price-earnings valuation ratio (P/E ratio) is calculated. The EPS figures in the earnings variable of the P/E ratio.
Limitations of EPS
It helps to remember though that EPS can be impacted by a company’s change in policies. EPS may also give a clear picture of a company and its position when the firm opts for buyback of shares or when there are mergers and acquisitions. Also, different companies may have their own accounting methods or principles, and in some situations, EPS may not be comparable.
Earnings per share is an important measure that indicates a company’s financial health and profitability. It is computed by dividing a company’s net income by the total outstanding shares. Traders and analysts use the EPS formula to compare two firms in the same sector or industry and take a call on their relative merits.