Do you want to know about the metric Earnings Per Share? You may already know that this is an indicator of profitability of a company. In this post, you will not only see what EPS is, but you will also learn to interpret EPS. More importantly, you will know how it can impact your investments.
You will also learn about a second related metric called Diluted EPS. At times, this overlooked metric is even more important than EPS. You will know why at the end of this article.
What Is Earnings Per Share (EPS)?
Profit of a company per share is called EPS. For example, let profit of a company be 10,000$. Assume that the company has issued 1000 shares in total. If you divide the profit by total number of shares, you will get the earnings per share or EPS value. In this case, the EPS will be 10$.
What is you know EPS but do not know the company’s profit?
If you multiply the earnings per share with the number of shares, you will get the profit of the company.
What Is The Formula To Calculate Earnings Per Share?
You have to use the below formula to calculate EPS.
EPS = (Net Income – Dividends On Preferred Stocks) / Number Of Outstanding Shares
Does this formula sound too technical? The below explanation will help you understand better.
Let us discuss the terms used in the EPS formula.
Net Income is nothing but the difference between revenue and expenses (with taxes). In simple words, net income is nothing but the profit of the company after taxes.
Preferred Stocks: There will be stocks on which the company has to pay dividends before paying to others. For example, assume that a company borrows funds from an organization. In return, the company issues stocks to the lending organization. Also the company agrees to pay special dividends to these stocks. In this scenario, the stocks owned by the lending organization are a type of preferred stocks.
Number Of Outstanding Shares: The number of outstanding shares refers to the average number of total outstanding shares issued by the company. This not a single fixed number but an average for a reason. Let us assume that you want to calculate EPS of a company for a full year. Between the start and the end of the year, the company may issue additional shares. (Number of additional shares will depend upon the capital requirements of the company.) Therefore the number of outstanding shares will be a weighted average of the total shares issued during this full year period.
But what exactly is weighted average? The calculation of this metric is tricky and can be left to mathematicians. But here is the basic principle. Shares issued for a full year will have more importance than shares issued in the last few months. The importance of shares based upon the time of issue will be incorporated into the weighted average.
How Often EPS Is Calculated?
If you know the profit of a company for a particular time frame, you can calculate EPS for that time frame. For example, if a company makes a profit of 1000$ for 3 months and it has issued 100 shares, then its
EPS for 3 months = 1000/100 = 10
Every company issues quarterly results. Therefore, you should be able to easily calculate EPS for every quarter. But many investors give more importance to yearly EPS than quarterly EPS. You will know the reason in the next paragraph.
Quarterly EPS can be misleading at times. If a company has invested in new purchases in a particular quarter, its quarterly EPS may look negative. You should not conclude that the company has not performed well in the quarter. Using the new purchases, the company may perform well in the next quarters. Therefore, it is better to calculate EPS for a larger time frame like 1 year or 2 years.
How Often EPS Is paid?
Do you want to know whether a company will pay the earnings per share (as dividends)? If yes, do you want to know how often will the company pay? (After all, the profit is made using the capital received from shareholders.)
A company may decide to pay or not to pay dividends. Even if the company decides to pay, the dividends per share may not be equal to the earnings per share. The company may pay a fraction of the EPS as DPS (Dividend Per Share), and use the remaining for company’s growth. The decision to pay dividends and the actual dividend per share amount will be decided by the board.
What Is Diluted EPS?
A diluted EPS is a metric that gives more accurate picture of the profitability of the company. Before seeing what diluted EPS is, consider the following scenario.
Assume a scenario that a company wants to raise debts and reduce employee costs.
To raise debts it approaches lending organizations and issues them securities. It signs an agreement that the lending firms can convert the securities into stocks at a later point of time. The lending organizations, after assessing the potential of the company, will be happy to lend money in exchange for the convertible securities (i.e securities that can be converted into stocks at a later point in time.)
Similarly, to cut down employee costs, the company issues stock options instead of bonuses. This is the equivalent of saying to the employee, “Hey you work hard towards growth of the company, but we are short on our finances to pay bonuses today. But here are your securities, which you can convert to stocks at a later point in time”. If the organization grows, the value of stocks grow and any employee will be able to convert his securities to real stocks without paying a penny.
In both of the above cases, the company issued convertible securities. In first case it was to lending organizations and in second case it was to employees. After few years, assume that the company makes a handsome profit of $100 million. Due to company’s good performance, the stock value will also most likely grow handsomely. In such scenario some lenders and employees will convert the securities given to them into real stocks.
Diluted EPS takes into account, both common stocks as well convertible securities.
.A simplistic formula for diluted EPS is as follows:
Diluted EPS = (Net Income – Preferred Dividends) / (Common Stocks + Convertible Securities)
How Profit Of A Company Is Calculated?
Now you know that both EPS and diluted EPS are calculated based on profit of a company. But how exactly you will know or calculate the profit? It is not a difficult task because any company will release its income statement on a quarterly and yearly basis. You will find something called net income in those statements. This net income is the difference between company’s expenses and revenues. The expenses will also include taxes paid by the company. This net income is the profit.
Profit (or net income) = Revenues – Expenses (including taxes)