EARNING PER SHARE- EPS OF A SHARE AND ITS IMPORTANCE FOR SHARE INVESTORS

EARNING PER SHARE- EPS OF A SHARE 

AND ITS IMPORTANCE FOR SHARE INVESTORS

Earnings per share (EPS) is calculated as a company's profit divided by the outstanding shares of its common stock. The resulting number serves as an indicator of a company's profitability. It is common for a company to report EPS that is adjusted for extraordinary items and potential share dilution. The higher a company's EPS, the more profitable it is considered.

Formula and Calculation for EPS

The earnings per share value are calculated as the net income (also known as profits or earnings) divided by the available shares. A more refined calculation adjusts the numerator and denominator for shares that could be created through options, convertible debt, or warrants. The numerator of the equation is also more relevant if it is adjusted for continuing operations.



To calculate a company's EPS, the balance sheet and income statement are used to find the period-end number of common shares, dividends paid on preferred stock (if any), and the net income or earnings. It is more accurate to use a weighted average number of common shares over the reporting term because the number of shares can change over time.

Any stock dividends or splits that occur must be reflected in the calculation of the weighted average number of shares outstanding. Some data sources simplify the calculation by using the number of shares outstanding at the end of a period.

Example

The calculation of EPS for three companies at the end of the 2017 fiscal year follows:

Company	Net Income	Preferred Dividends	Weighted Common Shares	Basic EPS
Ford	$7.6B	$0	$3.98B	$7.6/$3.98 = $1.91
Bank of America	$18.23B	$1.61B	$10.2B	$18.23-$1.61/$10.2 = $1.63
NVIDIA	$3.05B	$0	$.599B	$3.05/$.599 = $5.09

Understanding Earnings per Share

The earnings per share metric are one of the most important variables in determining a share's price. It is also a major component used to calculate the price-to-earnings (P/E) valuation 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 used 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, 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, the total number of shares that could be created and issued from NVIDIA's convertible instruments for the fiscal year ended in 2017 was 33 million. If this number is added to its total shares outstanding, its diluted weighted average shares outstanding will be 599 million + 33 million = 632 million shares. The company's diluted EPS is, therefore, $3.05B / 632 million = $4.82.

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 fo 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 sits has become very valuable as new developments have surrounded it over the last 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.

While 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 calculation for EPS excluding extraordinary items is:



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.

How is EPS calculated?

In a nutshell, EPS formula is –

EPS = (Net Income − Preferred Dividends)/End-of-Period Common Shares Outstanding

For instance, 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 is 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 EPS ratio tends to depend on the type of earnings that have been used to arrive at it, it is vital to achieving familiarity with them in general.

Types of Earnings Per Share

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 –

I.            Trailing EPS: It is entirely based on the previous year’s figures.

II.            Current EPS: Mostly based on the current projections and available figures.

III.            Forward EPS: Depends on anticipated future projections and estimated figures.

To begin with, there are 5 types of earnings per share example –

§  Reported EPS or GAAP EPS

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.

§  Ongoing EPS or Pro Forma EPS

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.

§  Retained EPS

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 which 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 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.

Cash EPS

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

Book Value EPS

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 –

EPS Variations	Calculations
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	Summation of net earnings and current retained earnings is subtracted from divided 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.

Importance of Earnings Per Share

The following pointers highlight how important earnings per share is when it comes to measuring a company’s profitability and financial standing –

§  It helps gauge if investing in a company would help investors generate more income. To elaborate, a higher EPS indicates a profitable status, which in turn, suggests that the company may increase dividend payout over time.

§  Also, helps compare the performance of promising companies to help pick the most suitable investment option.

§  Similarly, with the help of EPS investors and other financial methods, one can determine a company’s existing and anticipated stock value. Further, helps analyse if its stock price is valued as per its market performance. For instance, investors use the Price Earnings Ratio along with Price Earnings Ratio to measure the same. In the Price earnings formula (P/E), ‘E’ stands for earnings, which is computed with the help of the EPS formula.

§  EPS not only helps measure a company’s current financial standing but also helps track its past performances. For instance, a company with a steadily increasing EPS is often considered to be a reliable investment option. Likewise, companies with faltering or irregular EPS are usually not preferred by seasoned investors.

Limitations of Earnings Per Share

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 –

I.            Most business owners tend to manipulate the EPS frequently to project their venture as a profitable one. However, most of such attempts are made for the short-term, which often hampers a business venture image and profitability in the long-run.

II.            Since EPS does not consider inflation, the growth indicated by it may not be accurate in the first place. For instance, with inflation, the overall price of goods and services also increases. This, in turn, projects a misleading EPS value if the venture fails to purchase or sell more goods than it did a year ago.

III.            Cash flow is an important aspect when it comes to gauging a company’s ability to repay its debt. However, cash flow is not factored in EPS calculation which means a high EPS may still prove ineffective for gauging a company’s solvency.

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.

Understanding Earnings per Share

The earnings per share metric are one of the most important variables in determining a share's price. It is also a major component used to calculate the price-to-earnings (P/E) valuation 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 used 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, 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, the total number of shares that could be created and issued from NVIDIA's convertible instruments for the fiscal year ended in 2017 was 33 million. If this number is added to its total shares outstanding, its diluted weighted average shares outstanding will be 599 million + 33 million = 632 million shares. The company's diluted EPS is, therefore, $3.05B / 632 million = $4.82.

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 fo 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 sits has become very valuable as new developments have surrounded it over the last 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.

While 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 calculation for EPS excluding extraordinary items is:



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.