Earnings-per-share Ratio For Company Performance
Investors use many metrics when it comes to evaluating the financial performance of a company; one of the quickest and strongest instruments they can use is earnings-per-share ratio (EPS). EPS is a good indicator of profitability because it accounts for the profit that is attributed to shares that a company has issued. EPS is useful, but EPS should be interpreted in the context of its limitations.
What Does EPS Stand For?
Earnings-per-share (EPS) gives investors a sense of how much profit a company generates for every share of its stock. And this commonly accepted measure reflects how much profit a firm is generating.
EPS Formula:
(Net Income − Preferred Dividends) / Average Outstanding Shares.
EPS is also a major component in calculating the popular price-to-earnings (P/E) ratio, in which the “E” stands for earnings-per-share. When analyzing a company, it becomes vital to understand the different kinds of EPS like basic EPS, diluted EPS, and adjusted EPS.
EPS Overview
EPS is a way to identify how much of a company's profit is in relation to how many shares are currently out there. Businesses with high EPS are generally perceived as more profitable; however, EPS alone does not tell the complete story. It should be used by investors along with other metrics and qualitative features for a more comprehensive analysis.
How to Calculate EPS
To calculate EPS:
- Use the weighted average number of shares outstanding.
- Divide that figure by the total number of outstanding shares.
Net income is the profit remaining after all expenses have been subtracted. Preferred dividends are deducted because preferred shareholders are entitled to fixed dividend payments.
EPS Calculation Example
Imagine a company with:
- Net income: $4 billion
- Shares outstanding: 400 million
- No preferred stock issued.
To calculate EPS, divide $4 billion by 400 million = $10.
If there were $400 million in preferred dividends:
- Net income: $4 billion
- Preferred dividends: $400 million, leaving $3.6 billion.
- Shares outstanding: 400 million.
Take $3.6B divided by 400M, resulting in an EPS of $9. This illustrates how EPS is affected in the presence of preferred dividends.
How Investors Use EPS
EPS is important for assessing profitability and is a key component in determining the price-to-earnings (P/E) ratio. Investors evaluate how the market values a company’s earnings by dividing a company’s stock price by its EPS.
Drawbacks of EPS
EPS is an important metric, but it has its shortcomings:
- Dependency on net income: EPS is dependent on net income, which can be impacted by variable expenses or capital investments.
- Effect of non-operating expenses: Higher non-operating costs such as taxes or interest can affect EPS.
- Limited diagnostic information about operations: EPS does not always show the true performance of a company or its rate of cash flow.
EPS is just one part of the puzzle, and analysts will turn to other metrics to get a fuller picture.
Basic EPS vs. Diluted EPS
Basic EPS
Basic EPS measures earnings per current share outstanding for a simple way to gauge profitability for current owners.
Diluted EPS
Diluted EPS accounts for shares that could potentially be issued by convertible debt or stock options, giving the most conservative estimate of profitability.
Example:
- Net income: $450 million
- Outstanding shares: 95 million
- Stock options: 5 million
Diluted EPS: $450 million / 100 million = $4.50.
Diluted EPS takes into consideration potential dilution, helping us see how much profit we can expect in the future.
Comparison
- Basic EPS: Based on existing shares; snapshot of profitability; ignores dilution.
- Diluted EPS: Includes potential shares; more conservative measure; accounts for dilution impact.
EPS and Adjusted EPS
Adjusted EPS does not include nonrecurring items, which are one-time expenses or gains, to offer a clearer picture of core profitability. Yet companies sometimes adjust earnings in ways that inflate adjusted EPS, so investors should scrutinize adjustments carefully.
Comparison:
- Basic EPS: Simpler calculation, includes total reported earnings, limited by unusual factors.
- Adjusted EPS: Accounts for nonrecurring items, focuses on core profitability, filters out major events for improved understanding.
What is a Good EPS?
What constitutes a good EPS varies by industry and circumstances. Look at year-on-year EPS growth, not just the absolute value of EPS. To gain a complete picture, use EPS analysis alongside derivatives like the P/E ratio, earnings yield, and comparisons to industry competitors.
Key Takeaways
EPS gives us a quick overview of profitability but needs to be viewed in context. To make comprehensive investment decisions, look at other metrics and qualitative elements to overall evaluate a company’s financial health and growth potential.