What is Earning Per Share (EPS)?
The term Earnings per Share (EPS) represents the portion of a company's earnings, net of taxes and preferred stock dividends, that is allocated to each share of common stock. Earnings per share serve as an indicator of a company's profitability.
EPS = (Net Income – Preferred Dividend) / Average Outstanding Shares
EPS can be calculated via two different methods: basic and fully diluted.
Basic EPS simply put is the EPS which accrues to the shareholders of the company. This is derived by dividing the net profit (after deducting dividend on preference shares) of a company by the total number of shares outstanding
First we will talk about why diluted EPS is important when evaluating companies. Assuming a company needs to raise debt and it realizes that it would be able to get cheaper debt by issuing convertible bonds rather than plain vanilla bond or it decides to reward its employees with stock options instead of bonuses. In these cases, when the convertible bond is converted or stock option is purchased, it will result in increase in number of shares for the company. For existing shareholders this will result in a lower EPS accruing to them. So a diluted EPS gives what the EPS of a company would be if all convertible bonds, convertible warrants, convertible preference shares and stock options outstanding on the company’s books are converted into shares. This will give the equity share holder the correct picture when investing in the company.
Fully diluted EPS – this method factors the potentially dilutive effects of warrants, stock options and securities convertible into common stock. It is generally viewed as a more accurate measure and is more commonly cited
EPS can be subdivided further according to the time period involved. Profitability can be assessed by prior (trailing) earnings, recent (current) earnings or projected future (forward) earnings.
Trailing EPS is the sum of a company's earnings per share for the previous four quarters.
Forward EPS is a measure of the price-to-earnings ratio (P/E) using forecasted earnings for the P/E calculation. While the earnings used are just an estimate and are not as reliable as current earnings data, there is still benefit in estimated P/E analysis. The forecasted earnings used in the formula can either be for the next 12 months or for the next full-year fiscal period.
How it works?
Assume that a company has a net income of Rs. 25 million. If the company pays out Rs. 1 million in preferred dividends and has 10 million shares.
EPS = [Net Income (25 million) – Preferred Dividend (1 Million)] / Average Outstanding Shares (10 million Shares). Hence EPS is 2.4.
In the same example if the company had 10 million shares for half of the year and 15 million shares for the other half, then EPS would be [Net Income (25 million) – Preferred Dividend (1 Million)] / Average Outstanding Shares (10 million+15 million Shares/2). (24/12.5). Hence EPS is 1.92.
Why it matters?
Earnings per Share are generally considered to be one of the most important variables in determining a share's price. Earnings per share are an important barometer to gauge a company's profitability per unit of shareholder ownership.
An important aspect of EPS that's often ignored is the capital that is required to generate the earnings (net income) in the calculation. Two companies could generate the same EPS number, but one could do so with less equity (investment) - that company would be more efficient at using its capital to generate income and, all other things being equal would be a "better" company. Rate of Growth of EPS is Important and this may be compared between different companies and over time within the same company
Though earning per share is widely considered to be the most popular method of quantifying a firm's profitability, it's important to remember that earnings themselves can often be susceptible to accounting changes and restatements.
We will explain Return on Equity (ROE) in the next edition on Mirae Asset Knowledge Academy Tutorials.
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