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Earnings Per Share (EPS) Defined

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To the average investor, a company’s gross revenue is a measure of success. But, if you’re a smart blue chip stock investor, you’ll have to drill into the fine print when considering buying a stock, and this will lead you to the most important metric — earnings per share. Blue chip stocks are shares of companies that are financially stable, reputable and long-established within their niche.

Earnings per Share (EPS) Meaning

Earnings per share is a widely followed performance measure that portrays a company’s financial health. This figure describes the portion of a public company’s profit that is allocated to each outstanding share of its stock, calculated quarterly or annually. EPS is arrived at by taking a company’s annual or quarterly net income and dividing by the shares outstanding (the company’s stock currently held by the shareholders).

This metric is a basic yardstick for any company’s profitability and tells investors whether the company is a safe bet. A company with a high earnings per share is perceived to be more profitable.

How to Calculate Earnings per Share with a Formula

The EPS calculation is simple — Take the company’s net earnings and divide it by the number of outstanding shares. In a formula:

Earnings per share = Net income / Common shares

The 2 data points that make up the EPS ratio are easy to get on a company’s quarterly earnings reports. You can also find EPS listed on a firm’s quarterly report, but you should know how to calculate it.

Some companies may have preferred stock — shares that give owners the right to receive a portion of the company’s profit (dividend). When calculating EPS for such companies, the dividends paid on preferred stocks must be deducted from the net income as shown in the formula below:

Earnings per share = (Net income – Preferred dividends) / Common shares

The income statement and balance sheet are used to obtain the period-end net earnings or income, number of common shares and any dividends paid on the preferred stock. It is accurate to use a weighted average number of common shares over the specified reporting term since the number of shares could fluctuate over time.

Example Calculation of Earnings per Share

These are some examples to better understand EPS:

BYND

For the year ending Dec. 31, 2019, BYND has a net income of $10,500,000. The company had 2,000,000 common shares outstanding. There was no preferred stock, repurchases or new issues. Therefore, basic EPS of BYND is:

Earnings per share = Net income / Common shares

Earnings per share = 10,500,000 / 2.000.000 = 5.25

So, basic EPS = $5.25 per share

3M

For the year ending Dec. 31, 2018, 3M had a net income (after tax) of $2,000,000 and paid out $400,000 in preferred dividends. The average number of common shares outstanding during the period was 800,000 shares. 3M’s earnings per share is calculated:

Earnings per share = (Net income – preferred dividends) / Common shares

Earnings per share = (2,000,000-400,000) / 800,000 = 2

Basic EPS for 3M = $2 per share

Diluted Earnings per Share vs. Basic Earnings per Share

Basic EPS and diluted EPS are profitability metrics used in analyzing companies. Basic EPS takes into account a firm’s common shares while diluted EPS takes into account all convertible securities — investments that can be changed into a different form. Common convertible securities include convertible preferred stocks and bonds that can be converted into common stock.

What is Basic EPS?

EPS measures a company’s profit on a per-share basis. Contrary to diluted earnings per share, basic EPS doesn’t account for the dilutive effects that the convertible securities could have on EPS. Typically, dilutive effects happen when there’s an increase in the number of shares, for instance, through a new issue. If more shares are issued to shareholders and investors, the number of common shares outstanding increases and the EPS decreases. Ultimately, this could lower the stock price.

A company’s basic EPS is calculated by taking the net income less preferred dividends divided by the average number of common shares. You can refer to the 3M example above.

What is Diluted EPS?

Diluted EPS is an important measure in a company’s fundamental analysis and is used to assess the quality of earnings after deducting all convertible securities. The diluted EPS usually adjusts the basic EPS figure by factoring in any potential dilution that could lower the reported EPS, if triggered.

Profits can be lost or “diluted” on their way to shareholders for various reasons. An acquisition or merger might result in the issuance of new shares or employees may have convertible preferred stocks. 

Diluted EPS is calculated by taking a firm’s net income minus preferred dividends. Then you divide by the number of shares outstanding plus the effect of all dilutive potential shares outstanding. Diluted potential shares outstanding include all convertible preferred shares, options and securities.

Earnings per share = (Net income – Preferred dividends) / (Average common shares + Diluted potential shares)

Let’s say for the year ending Dec. 31, 2018, 3M had a net income (after tax) of $2,000,000 and also paid out $400,000 in preferred dividends. The average number of common shares outstanding during the period was 800,000 shares. If the company had employee stocks convertible to 100,000 common shares and preferred shares convertible to 100,000 common shares. The diluted EPS is:

Earnings per share = (Net income – Preferred dividends) / (Average common shares + Diluted potential shares)

Earnings per share = (2,000,000 – 400,000) / (800,000 + 100,000 + 100,000) = 1.6

The diluted EPS = $1.6

If a company owns any convertible securities, then its diluted EPS is less than the basic EPS.

Why is Earnings per Share Important for Investors?

Why are earnings per share important? Here are a few clues investors can learn.

It Drives Stock Prices

Investors pay close attention to a company’s EPS since it can drive the stock price. If a company records strong earnings for a quarter, it is an indicator that stock prices might increase. Conversely, if the earnings are dropping, this is an indication of decreasing stock prices. Since various factors have a hand in this evaluation, investors can never be sure this prediction will materialize.

A Measure of Profitability

EPS, as a metric, is essential in measuring a company’s profitability. And when it comes to fundamental analysis, this is the only metric that isolates a company’s net income to reveal what shareholders are earning by investing in the company. Simply put, companies are usually in the market to conduct business and make profits, and investors put their money in companies to enjoy part of the profits. 

A consistently growing EPS implies that an investor is receiving a share of the company’s growing profits. Besides, a growing EPS shows that a company is creating some value for the investors. On the contrary, a negative or falling EPS indicates consistent losses or low profitability, financial trouble and eroding investor value.

Earnings per share simply answers 2 main questions for investors: How much profit per outstanding share is the company making? And, how much profit does the shareholder accrue?

An Indicator of Dividend Payout

Dividends are usually a percentage of company profits distributed to shareholders and provide a steady income to investors. Dividends are also seen as strong growth and a positive sign for a company’s future. A company only gives dividends if there are excess earnings per share. Although dividend payout isn’t directly related to earnings per share, it is commonly seen that companies with a stable or growing EPS consistently pay dividends to shareholders. Though many other factors are taken into account before dividend payout, investors interested in dividend income should evaluate a company’s EPS prior to investing.

What are Some Limitations of EPS?

Despite the several clues investors can learn through EPS, there are limitations associated with it. Some of these limitations are:

  • Companies can easily manipulate their earnings per share by reducing the number of outstanding shares. A company can buy back its own shares, therefore reducing the common shares outstanding. This automatically increases the EPS figure.
  • EPS doesn’t take into account the company’s debt position, a factor that any discerning investor should be aware of.
  • EPS does not capture a company’s performance since it fails to consider the price of a share.
  • EPS can be distorted by acquisitions and mergers. For instance, a deal will give more earnings if the acquiring company’s P/E ratio is greater than the acquired company’s P/E ratio.
  • Although EPS is an important ratio to understand, it should not be the only factor driving your investing decision. EPS alone doesn’t tell a company’s entire story. You should also pay close attention to the price-to-earnings ratio for better insight.

Given these limitations of EPS, you shouldn’t use it alone to make an investing decision.

EPS vs. P/E Ratio

EPS and the P/E ratio are widely-used metrics in selecting stock. Although they are often used interchangeably, both metrics speak differently about a company and its stocks. EPS is used to determine how profitable a company is whereas P/E ratio tells how much you’re paying in invest in a company based on its profits.

EPS is obtained by taking a company’s net earnings minus preferred dividends divided by the common shares. This gives the net profit earned by every share and is a key component in stock price valuation. EPS also gives a clear picture of how much you’re earned for every share you own.

The P/E ratio shows the relationship between the market value of a company’s stock and its earnings per share. This figure is important in predicting the future value of a company’s stock.

For example, if Starbucks Inc. earns $4 per share and is trading at $40 per share (market value), the P/E ratio will be 40/4, or 10. This implies that investors are willing to pay $10 for each dollar of earnings.

  • High P/E: Companies that have a high P/E ratio are considered growth stocks. The high P/E shows a positive future performance. Investors have high expectations for the growth in future earnings and are willing to pay more for them. The drawback to this is that growth stocks are highly volatile and companies are often under a lot of pressure to justify the higher valuation. As a result, investing in growth stocks is considered a risky investment.
  • Low P/E: Companies with a low P/E are considered value stocks. They are undervalued and the mispricing could be a great bargain for investors who buy the stock before the market corrects it. So, investors can make huge profits from the higher stock price.

Know Your Earnings per Share

Earnings per share is an important indicator when assessing a company’s financial health. EPS is often an indicator that a company is making the right move towards profitability. However, EPS may not reveal the whole story about a company. This metric could also be manipulated by companies that buy back their shares. So before buying stocks in any company, ensure the investment correctly aligns with all your financial goals.

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