EPS Formula: Earnings Per Share Calculation

When assessing a company's financial health, one crucial metric that investors often consider is Earnings Per Share (EPS). EPS provides valuable insights into a company's profitability by revealing how much profit is allocated to each outstanding share of common stock. So, what is EPS, its formula, and significance? Let's find out. .

What is EPS?

EPS is a financial ratio that goes beyond just looking at a company's overall earnings. It focuses on breaking down those earnings on a per-share basis, allowing you to understand the profitability associated with each individual share of common stock. In other words, EPS shows how much profit a company generates for each outstanding share.

By calculating EPS, you can assess the company's profitability and evaluate its potential returns. This ratio enables you to compare companies within the same industry and determine which ones generate higher profits per share. A higher EPS indicates that a company utilises its resources effectively to increase shareholder earnings.

EPS is one of the most widely used indicators in investment decisions because it directly links a company’s performance to shareholder value. Analysts and investors rely on EPS to gauge financial health, assess growth potential, and predict future performance. It also forms the basis of valuation metrics like the Price-to-Earnings (P/E) ratio, making it a critical factor in determining whether a stock is fairly priced or overvalued.

EPS Formula

Now that you know what EPS is, let us see the formula used to derive it. The earnings per share formula is as follows:

EPS = (Net Income - Preferred Dividends) / Average Outstanding Shares, where:

• Net income represents the company's total earnings after accounting for expenses, taxes, interest, and preferred dividends. It is there in the company's income or profit and loss statements.

• Preferred dividends are paid to preferred stockholders who hold a different class of shares than common stockholders. Preferred dividends get deducted from net income because they are distributed before any earnings are allocated to common stockholders.

• Average number of outstanding shares during the reporting period is the total number of shares issued by the company and held by investors. The average outstanding shares can be calculated by taking the sum of the beginning and ending outstanding shares and dividing it by two.

So, as per the earnings per share calculation formula, if a company has a net income of Rs. 50 lakhs and has to pay dividends worth ₹5 lakhs with ₹10 lakh average outstanding shares, its EPS stands at:

EPS = (50,00, 000 - 5,00,000)/10, 00,000 = Rs. 4.5 per share

How is EPS Used?

EPS is a versatile metric used in various ways to assess a company's financial health. Investors often rely on EPS to compare profitability among companies within the same industry. A higher EPS indicates better profitability, making the company more attractive to investors. Additionally, EPS serves as a critical component in valuation metrics such as the Price-to-Earnings (P/E) ratio. By dividing the current stock price by the earnings per share, you can gauge whether a stock is overvalued or undervalued relative to its earnings. This comparison helps in making informed investment decisions.

Example of EPS

To illustrate the earnings per share formula, let's consider a hypothetical example.

Company ABC has a net income of ₹10 crores for the fiscal year. The company has issued 1 crore shares of common stock and has no preferred stock. The EPS calculation for Company ABC would be:

EPS = 10,00,00,000/1,00,00,000 = ₹10

This means that Company ABC has an EPS of ₹10, indicating that each share of common stock earned ₹10 in profit for the fiscal year.

EPS Significance

EPS holds significant importance for investors and financial analysts due to the following reasons:

• Measure of Profitability

EPS provides a per-share perspective of a company's profitability. By comparing the EPS figures of different companies within the same industry, investors can gauge which companies are generating higher profits per share.

• Assessing Growth

Changes in EPS over time can indicate a company's growth trajectory. Increasing EPS over consecutive periods suggests that the company is becoming more profitable, which can attract potential investors.

• Investment Decision-making

Investors often utilise EPS as a factor in their investment decision-making process. Higher EPS figures may influence investors to purchase or hold shares, indicating potential dividends and capital appreciation.

• Comparative Analysis

EPS allows for easy comparison between companies of different sizes. By considering EPS rather than total earnings, investors can compare companies' relative profitability, regardless of their market capitalization.

Different Types of EPS

• Basic EPS: Basic EPS is the most commonly used type of EPS. It is computed by dividing the company's net income with the weighted average number of outstanding common shares during a specific period.

• Diluted EPS: Diluted EPS considers the potential dilution of earnings per share from the conversion of convertible securities, such as stock options, convertible bonds, or preferred shares. It provides a more conservative measure of EPS by assuming that all potentially dilutive securities are converted into common shares.

• Trailing EPS: Trailing EPS is based on historical data and represents the earnings per share over the past four quarters or the most recent fiscal year. It provides a backward-looking perspective on a company's profitability.

• GAAP EPS: GAAP (Generally Accepted Accounting Principles) EPS represents the earnings per share calculated in accordance with the standard accounting principles of the country where the company operates. It ensures consistency and comparability in financial reporting.

• Forward EPS: Forward EPS, also known as projected or estimated EPS, provides an estimate of a company's future earnings per share. It is often based on analysts' forecasts and can help investors gauge the company's expected performance. .

• Adjusted EPS: Adjusted EPS is derived by adjusting the reported net income to exclude certain one-time or non-recurring items, such as restructuring charges, profits or losses from the sale of assets, or extraordinary expenses. It aims to provide a clearer view of the company's ongoing or core profitability.

EPS and Capital

EPS plays a significant role in determining a company's capital structure and investment decisions. Companies with higher EPS can generate more internal capital, which can be reinvested in the business for growth or used to pay dividends to shareholders. This reinvestment can lead to increased profitability and higher stock prices in the long run. Conversely, companies with lower EPS may face challenges in raising capital and attracting investors. Such companies might need to rely on external financing, which can increase their debt levels and financial risk.

EPS and Dividends

EPS directly influences a company's dividend policy. Companies with consistent and high EPS are more likely to pay regular dividends to shareholders. Dividends provide a steady income stream to investors and can make the stock more appealing. However, not all companies with high EPS pay dividends. Some companies may choose to reinvest their profits to fuel growth and expansion. As an investor, you should consider a company's dividend policy alongside its EPS to understand its approach to capital allocation.

EPS and Price-to-Earnings (P/E)

The P/E ratio is a widely used valuation metric that compares a company's stock price to its earnings per share. The formula for the P/E ratio is

P/E Ratio= Current stock price / EPS

A high P/E ratio may indicate that the stock is overvalued, while a low P/E ratio could suggest that the stock is undervalued. However, the P/E ratio should be used in conjunction with other financial metrics and industry benchmarks to make a comprehensive assessment.

What Is Rolling EPS?

Rolling EPS refers to the earnings per share calculated over the most recent twelve-month period, also known as trailing twelve months (TTM). Unlike annual EPS, which is restricted to a single financial year, rolling EPS is updated continuously by adding the latest quarter’s earnings and dropping the earliest one from the calculation. This approach provides a more current and realistic picture of a company’s profitability, especially during periods of rapid growth or decline. Investors and analysts use rolling EPS to track performance trends, compare companies, and make timely investment decisions. It helps assess whether earnings are consistently improving or weakening over time.

What is a Good EPS?

Determining what constitutes a "good" EPS depends on various factors, including the industry, company size, and economic conditions. Generally, a higher EPS is considered favourable as it indicates better profitability. However, as an investor, you should compare a company's EPS with its historical performance and industry peers to get a clearer picture. For instance, a tech company might have a higher EPS compared to a manufacturing company due to differences in business models and profit margins. Therefore, it's essential to consider the context and industry standards when evaluating EPS.

What is the Difference Between Basic EPS and Diluted EPS?

Basic EPS and diluted EPS are two variations of the earnings per share ratio formula. Basic EPS is calculated using the average number of outstanding shares, while diluted EPS considers the potential dilution from convertible securities such as stock options, warrants, and convertible bonds. Diluted EPS provides a more conservative estimate of a company's profitability by accounting for the potential increase in the number of shares. As an investor, you should consider both basic and diluted EPS to understand the impact of potential dilution on earnings.

What is the Difference Between EPS and Adjusted EPS?

Adjusted EPS is a variation of the traditional EPS metric that excludes one-time items and non-recurring expenses from the EPS calculation. These adjustments provide a clearer picture of a company's core operating performance by removing anomalies that can distort earnings. For example, a company might exclude restructuring costs, legal settlements, or asset impairments from its adjusted EPS calculation. By focusing on adjusted EPS, you can gain insights into the company's underlying profitability and make more informed investment decisions.

EPS Limitations

• Impact of Share Buybacks

When a company repurchases its own shares, the number of outstanding shares decreases. This artificially boosts EPS, even if the company’s actual profits remain unchanged. Investors must be cautious, as this does not necessarily reflect real business growth.

• Effect of Mergers and Acquisitions

Corporate actions like mergers or acquisitions can significantly alter earnings and the number of shares. These changes may inflate or deflate EPS figures, making it harder to judge a company’s true performance on a like-for-like basis.

• Differences in Accounting Practices

Companies often follow different accounting standards, methods of depreciation, or revenue recognition policies. Such variations mean that EPS figures across companies may not be directly comparable, even within the same industry.

• Potential Misleading Comparisons

Because of these factors, relying solely on EPS can lead to misleading conclusions. Investors should combine EPS with other financial ratios, like P/E ratio or return on equity, for a more accurate assessment.

To Sum Up

EPS is a valuable tool for investors to assess a company's profitability and make informed investment decisions. By examining the EPS formula and understanding its components, you can gain insights into a company's financial performance on a per-share basis. Remember that EPS should be evaluated in conjunction with other financial metrics and qualitative factors to form a comprehensive view of a company's prospects.