Table of Contents:
- What is EPS?
- Understanding the EPS formula
- Comparing earnings per share ratios
- Additional types of EPS
- Limitations of EPS
- Earnings per share (EPS) FAQs
- The bottom line
When investing in stocks, it’s not only important to understand your investment goals and risk tolerance, but it’s also important to do research on the companies you’re investing in. A common method used by investors to assess a company’s profitability is known as “EPS.”
So, what does EPS stand for? And how can understanding it help you reach your investment goals? Here’s everything you need to know about the popular investment metric.
What is EPS?
Earnings per share (EPS) is a dollar value that represents a public company’s profit in a given period. As part of a quarterly or annual earnings report, a company calculates its profit (aka earnings) per share.
EPS results can contribute to an investor’s decision to buy, sell, or hold.
- EPS meaning: Earnings per share (EPS) measures how much money a company earns from each of its shares of stock and is used by investors to assess the company’s profitability.
- EPS is the net profit divided by outstanding shares of the company’s stock.
- Diluted EPS is an additional variation of the metric, which accounts for the company’s convertible securities.
Understanding the EPS formula
When calculating EPS, the formula takes the company’s net income and divides it by the available shares. Net income is sometimes referred to as profits or earnings and is the amount of money the company has left after expenses have been paid.
The formula looks like this:
Earnings per share = net income – preferred dividends/end of period common shares
When calculating the EPS, you’ll need the company’s balance sheet and income statements to find the common shares, dividends paid on stocks, and net income. The best way to get the most accurate information is to calculate the weighted number of shares for that reporting period, since the number of shares can fluctuate over time. In addition, many companies include additional items such as significant gains or losses and possible share dilution, which we’ll discuss further.
Earnings per share in practice
Because the number of outstanding shares can vary during the year, you can get a more accurate calculation by using the weighted average number of shares. These steps can be used to calculate the weighted shares.
Step 1: Determine the number of outstanding shares after each change in common shares. This can include issuing new shares, which increases the shares, or repurchasing shares, which decreases the number of outstanding shares.
Step 2: Weigh the outstanding shares by the block of time between the changes.
Step 3: Total the weighted average number of shares outstanding.
As an example, let’s say Company X had a net income of $1,000,000 this year with no outstanding preferred stock shares. They had 50,000 shares outstanding during the year. The calculation would read: (1,000,000 – 0) / 500,000 = $2.0, meaning the company’s EPS equals $2.
What’s a good EPS ratio?
You might be wondering, is a high earnings per share ratio good? What’s an ideal EPS ratio?
To define a “good” EPS in stocks, several factors need to be taken into account. Those include the company’s recent performance, the competitor’s performance, and analysts’ expectations of the stock. As a rule of thumb, the higher a company’s EPS, the more likely it’s to be profitable. Still, as we well know, there’s no guarantee of performance in the future when it comes to investing.
It’s important to note that how a company reports expenses and earnings can manipulate the reliability of the EPS, so identifying accounting changes can help determine EPS accuracy.
Comparing earnings per share ratios
Comparing EPS ratios can be a helpful indicator when investing in stocks. When a company’s EPS shows continued growth over time, it can be a good sign that it’s able to maintain profitability. On the other hand, when you see dropping EPS numbers, it can be a sign the company’s losing money.
In addition to EPS, another factor to consider when looking at a company’s financial health is the price-to-earnings ratio (P/E ratio). A higher P/E ratio may indicate expected higher earnings or possibly suggest the company is overvalued. The more research done and metrics used in gathering data, the clearer picture you will get of a company and its financial health.
Additional types of EPS
The common EPS calculation is known as “basic” EPS. In addition to that, there are a few other types, including:
- Diluted EPS – considers the company’s convertible securities.
- Continuing operations EPS – only includes daily operations and not any discontinued operations, accounting alterations, or extraordinary items.
- EPS excluding extraordinary items – accounts for gains or losses on large assets.
Basic vs. diluted EPS
When reviewing a company’s income statement, knowing the difference between EPS and diluted EPS can help determine the calculation you’ll want to use to get the most accurate information. Basic EPS doesn’t account for additional stock options or warrants, which, if exercised, may increase the stock shares that are outstanding in the market.
This means that you’ll want to evaluate the business as a whole, how profitable it is, and the profits per share, since each share of stock represents ownership in that company.
- To review, the basic formula for EPS is:
Earnings per share = net income – preferred dividends/end-of-period common shares
- For comparison, the diluted EPS formula is:
Diluted earnings per share = net income – preferred dividends / total weighted average # shares + other dilutive securities
Investors interested in dividends will likely want to use the diluted EPS calculation. However, the reality is that despite a company’s profits, shareholders may not receive much per share, which isn’t great for investors who want to invest to receive dividends, so using the correct formula gives them a better idea of what to expect.
There are a few reasons shareholders may not see profits (diluted). For example, a merger with new shares being issued, or vesting periods coming to an end, can dilute a stock.
Limitations of EPS
Although EPS can offer some valuable information, there are disadvantages as well. For example, companies can alter their EPS by buying back stock, changing the number of outstanding shares, and making changes in their accounting and reporting to inflate their EPS. It can also be challenging to know if the company’s stock is undervalued or overvalued, since the price per share may not be accounted for.
Earnings per share (EPS) FAQs
Q: What is EPS in stocks, and what does the EPS calculation mean?
A: The EPS figure can help investors gain insight into a company’s profitability. Generally, the higher the number, the more profitable the company is, and the more investors want to own the stock, which may result in higher stock prices.
Q: Does EPS mean the same thing as dividends?
A: No. EPS calculates the profitability of a company, and dividends are the money paid to shareholders.
Q: What does a negative EPS finance mean?
A: A negative EPS can indicate that a company’s spending more than it’s earning or losing money, so other metrics should be considered when evaluating a company’s financial statements.
The bottom line
It’s an important step to evaluate a company’s financials before investing, and calculating the EPS can offer helpful information. That said, it’s also important to use additional parameters such as P/E ratios and other valuation methods to ensure your overall assessment of the company matches expectations for performance and profitability.