| EPS Example | ||||
|---|---|---|---|---|
| Company | Net Income | Preferred Dividends | Weighted Common Shares | Basic EPS |
| Company A | $7.6B | $0 | 3.98B | $7.6/3.98 = $1.91 |
| Company B | $18.23B | $1.61B | 10.2B | $18.23-$1.61/10.2 = $1.63 |
| Company C | $1.67B | $0 | 0.541B | $1.67/0.541 = $3.09 |
How Is EPS Used?
Earnings per share is one of the most important metrics employed when determining a firm's profitability on an absolute basis. It is also a major component of calculating the price-to-earnings (P/E) ratio, where the E in P/E refers to EPS. By dividing a company's share price by its earnings per share, an investor can see the value of a stock in terms of how much the market is willing to pay for each dollar of earnings.
EPS is one of the many indicators you could use to pick stocks. If you have an interest in stock trading or investing, your next step is to choose a broker that works for your investment style.
Comparing EPS in absolute terms may not have much meaning to investors because ordinary shareholders do not have direct access to the earnings. Instead, investors will compare EPS with the share price of the stock to determine the value of earnings and how investors feel about future growth.
Basic EPS vs. Diluted EPS
The formula in the table above calculates the basic EPS of each of these select companies. Basic EPS does not factor in the dilutive effect of shares that could be issued by the company. When the capital structure of a company includes items such as stock options, warrants, or restricted stock units (RSU), these investments—if exercised—could increase the total number of shares outstanding in the market.
To better illustrate the effects of additional securities on per-share earnings, companies also report the diluted EPS, which assumes that all shares that could be outstanding have been issued.
For example, say the total number of shares that could be created and issued from Company C's convertible instruments at fiscal year-end was 23 million. If this number is added to its total shares outstanding, its diluted weighted average shares outstanding will be 541 million + 23 million = 564 million shares. The company's diluted EPS is, therefore, $1.67 billion /.564 million = $2.96.
Sometimes an adjustment to the numerator is required when calculating a fully diluted EPS. For example, sometimes a lender will provide a loan that allows them to convert the debt into shares under certain conditions.
The shares that would be created by the convertible debt should be included in the denominator of the diluted EPS calculation, but if that happened, then the company wouldn’t have paid interest on the debt. In this case, the company or analyst will add the interest paid on convertible debt back into the numerator of the EPS calculation so the result isn’t distorted.
EPS Excluding Extraordinary Items
Earnings per share can be distorted, both intentionally and unintentionally, by several factors. Analysts use variations of the basic EPS formula to avoid the most common ways that EPS may be inflated.
Imagine a company that owns two factories that make cell phone screens. The land on which one of the factories sitshas become very valuable as new developments have surrounded it over the past few years. The company’s management team decides to sell the factory and build another one on less valuable land. This transaction creates a windfall profit for the firm.
Though this land sale has created real profits for the company and its shareholders, it is considered an “extraordinary item” because there is no reason to believe the company can repeat that transaction in the future. Shareholders might be misled if the windfall is included in the numerator of the EPS equation, so it is excluded.
A similar argument could be made if a company had an unusual loss—maybe the factory burned down—which would have temporarily decreased EPS and should be excluded for the same reason.
The Formula for EPS Excluding Extraordinary Items Is:
EPS=WeightedAverageCommonSharesNetIncome−Pref.Div.(+or−)ExtraordinaryItems
EPS From Continuing Operations
A company started the year with 500 stores and had an EPS of $5.00. However, assume that this company closed 100 stores over that period and ended the year with 400 stores. An analyst will want to know what the EPS was for just the 400 stores the company plans to continue with into the next period.
In this example, that could increase the EPS because the 100 closed stores were perhaps operating at a loss.By evaluating EPS from continuing operations, an analyst is better able to compare prior performance to current performance.
EPS and Capital
An important aspect of EPS that is often ignored is the capital that is required to generate the earnings (net income) in the calculation. Two companies could generate the same EPS, but one could do so with fewer net assets; that company would be more efficient at using its capital to generate income and, all other things being equal, would be a "better" company in terms of efficiency. A metric that can be used to identify more efficient companies is the return on equity (ROE).
EPS and Dividends
Although EPS is widely used as a way to track a company’s performance, shareholders do not have direct access to those profits. A portion of the earnings may be distributed as a dividend, but all or a portion of the EPS can be retained by the company. Shareholders, through their representatives on the board of directors, would have to change the portion of EPS that is distributed through dividends to access more of those profits.
EPS and Price-to-Earnings (P/E)
Making a comparison of the P/E ratio within an industry group can be helpful, though in unexpected ways. Although it seems like a stock that costs more relative to its EPS when compared to peers might be “overvalued,” the opposite tends to be the rule.
Regardless of its historical EPS, investors are willing to pay more for a stock if it is expected to grow or outperform its peers. In a bull market, it is normal for the stocks with the highest P/E ratios in a stock index to outperform the average of the other stocks in the index.
What Is a Good EPS?
What counts as a good EPS will depend on factors such as the recent performance of the company, the performance of its competitors, and the expectations of the analysts who follow the stock. Sometimes, a company might report growing EPS, but the stock might decline in price if analysts were expecting an even higher number.
Likewise, a shrinking EPS figure might nonetheless lead to a price increase if analysts were expecting an even worse result. It is important to always judge EPS in relation to the company’s share price, such as by looking at the company’s P/E or earnings yield.
What Is the Difference Between Basic EPS and Diluted EPS?
Analysts will sometimes distinguish between basic and diluted EPS. Basic EPS consists of the company’s net income divided by its outstanding shares. It is the figure most commonly reported in the financial media and is also the simplest definition of EPS.
Diluted EPS, on the other hand, will always be equal to or lower than basic EPS because it includes a more expansive definition of the company’s shares outstanding. Specifically, it incorporates shares that are not currently outstanding but could become outstanding if stock options and other convertible securities were to be exercised.
What Is the Difference Between EPS and Adjusted EPS?
Adjusted EPS is a type of EPS calculation in which the analyst makes adjustments to the numerator. Typically, this consists of adding or removing components of net income that are deemed to be non-recurring.
For instance, if the company’s net income was increased based on a one-time sale of a building, the analyst might deduct the proceeds from that sale, thereby reducing net income. In that scenario, adjusted EPS would be lower than basic EPS.
What Are Some Limitations of EPS?
When looking at EPS to make an investment or trading decision, be aware of some possible drawbacks. For instance, a company can game its EPS by buying back stock, reducing the number of shares outstanding, and inflating the EPS number given the same level of earnings.
Changes to accounting policy for reporting earnings can also change EPS. EPS also does not take into account the price of the share, so it has little to say about whether a company's stock is over or undervalued.
How Do You Calculate EPS Using Excel?
After collecting the necessary data, input the net income,preferred dividends,and number of common shares outstanding into three adjacent cells, say B3 through B5. In cell B6, input the formula "=B3-B4" to subtract preferred dividends from net income. In cell B7, input the formula "=B6/B5" to render the EPS ratio.
The Bottom Line
Earnings per share (EPS) is an important profitability measure used in relating a stock's price to a company's actual earnings. In general, higher EPS is better but one has to consider the number of shares outstanding, the potential for share dilution, and earnings trends over time. If a company misses or beats analysts' consensus expectations for EPS, its shares can either crash or rally, respectively.
