Earnings per share is used for evaluating the profitability of a company. It can simply be understood as the value of earnings per outstanding share of a company's common stock.
To simply define what is EPS, we can say that it is the share of a company’s profit that is distributed to each share of stocks. Further, it is considered to be a significant financial parameter as it helps to gauge a company’s financial health. To elaborate, higher EPS reflects greater profitability from the company and its overall ventures.
Here is how to calculate earnings per share with the EPS formula –
EPS = (Net Income − Preferred Dividends)/End-of-Period Common Shares Outstanding
Understand with a earnings per share example-
Suppose a company, XYZ, is left with a net income of Rs. 10 lakh and must also pay Rs. 2 lakh as preferred dividends and has Rs. 4 lakh common share outstanding (weighted average) at the current period.
Therefore, the EPS of XYZ Company as per earnings per share formula would be –
= Rs. (10,00,000 – 2,00,000)/ 4,00,000
= Rs. 2 per share
Typically, the company’s balance sheet and its income statement are relied upon for EPS calculation. Also, it is often recommended to opt for the weighted average number of common shares, as the number of shares may vary over a given period.
Notably, the dividends earned on both cumulative preferred stocks and non-cumulative preferred stocks tend to influence the resulting EPS differently.
For instance, to calculate the current EPS, the dividends on cumulative preferred stocks for the current period are subtracted from the net income. The step is followed even when the dividend has not been declared in a given year. On the other hand, dividends are generally not deducted from the net income of the current year unless had been declared by the management.
Since the EPS ratio tends to depend on the type of earnings that have been used to arrive at it, it is vital to achieve familiarity with them in general.
There are several variations of EPS, and each of them tends to signify a different aspect of this financial parameter. It is because, based on the use of EPS, a company’s stock appears to be undervalued or overvalued.
Generally, EPS is divided into 3 broad categories, namely –
To begin with, there are 5 types of earnings per share–
This variation is achieved by using the Generally Accepted Accounting Principles and is disclosed in the SEC filings. However, a company’s earnings can be distorted by GAAP.
To elaborate, the income generated through the one-time sale of machinery, if treated as operating income as per GAAP, could shoot the EPS upwards. Likewise, if business ventures decide to treat significant regular expenses as an unusual expense, it would directly boost the earnings per share artificially.
Also known as the Pro forma EPS, this variation is based on ordinary net income and tends to exclude anything that can be generally passed as an unusual one-time event.
Typically, it helps discover anticipated income from core business ventures but also does not help project a record that highlights the company’s real earnings.
Notably, the word proforma signifies that certain assumptions had been made during computation. For instance, certain income or expenses that were used to compute reported earnings are excluded in this EPS variation.
It signifies the amount of profit that a company decides to hold on to instead of distributing to its shareholders as dividends.
Business owners may opt to use the retained earnings to pay off existing debts for expansion purposes or may keep it as a reserve to meet future requirements.
Usually, profits that are not used within a given period are added to net earnings for the following accounting period. It helps arrive at the aggregate earnings for that period. Generally, such earnings are disclosed under the header of the stockholder’s equity in a balance sheet.
The retained earnings per share are computed by adding the net earnings to the current retained earnings and then subtracting the total dividend paid from it. Lastly, the remainder is divided by the total number of outstanding shares.
Therefore, the retained EPS calculation is completed using this formula –
Retained EPS = (Net earnings + current retained earnings) – divided paid/total number of outstanding shares
Conversely, if the retained earnings are negative in value, it is subtracted from the net earnings of the following accounting period.
It is one of the essential EPS variations as it helps gain a better idea about a company’s financial standing. It is because the Cash EPS signifies the exact amount of cash earned.
Also, unlike net income, it is quite difficult to manipulate this variation of earnings per share.
Further, it can be expressed as
Cash EPS = Operating Cash Flow/Diluted Shares Outstanding
Also known as Carrying value per share, this EPS variation enables individuals to compute the aggregate amount of company equity in each share.
Also, it comes in handy to estimate the worth of a company’s share in case it has to be liquidated. Usually, it is considered to be a static representation of a company’s performance as it mainly focuses on the balance sheet.
The table below offers an overview of the different types of EPS –
|Reported EPS or GAAP EPS||Calculated as per Generally Accepted Accounting Principles.|
|Ongoing EPS or Pro Forma EPS||Does not include a subject’s unusual one-time income in the net income.|
|Retained EPS||The summation of net earnings and current retained earnings is subtracted from the dividend paid. The outcome is further divided by the total number of outstanding shares.|
|Cash EPS||Total operating cash is divided by outstanding diluted shares.|
|Book Value EPS||Take the current balance sheet into account to compute the EPS.|
Diluted EPS and Basic EPS have certain same features, but in fact, they differ. In order to calculate basic EPS, you would have to divide a company's profit by the number of outstanding shares.
To calculate the Diluted EPS, it is necessary to consider all the possible dilutions, like when options are converted into shares.
Usually, the diluted EPS method is used while valuing a company in case the company is likely to witness a dilution because of ESOP or other similar instances. Otherwise, the Basic EPS method is optimal for computing the cash flows of the future period.
The following pointers highlight how important earnings per share is when it comes to measuring a company’s profitability and financial standing –
Although earnings per share are considered to be a potent financial tool, they must remember that EPS has its share of drawbacks.
The list below highlights a few of its limitations which must be remembered by both the investors and business owners –
Hence, before judging the merit of a company as an investment option, investors should also check other important factors as well. In fact, they should align Earnings per Share with other financial parameters to gain a fair idea of a business venture’s overall scope, profitability, and market performance.