What is EPS in Stocks and Why is it Important?
EPS (full form: Earnings Per Share) is a metric used to analyse a company’s performance. It indicates a company’s profitability and is useful for investors to make informed decisions. If you actively invest in stocks, EPS will help you dig deeper and conduct a fundamental stock analysis of a company you are interested to invest in. Read on to know EPS meaning, calculation, types, importance, limitations and more.
Earnings Per Share (EPS) is a metric used to determine how much a company makes per outstanding share. It allows investors to analyse how much profit a company has made in a year or a quarter. This indicates the financial health of a company. In simple terms, the higher the EPS, the better the profitability of a company. Usually, two formulas are used to calculate EPS. Check out the next section to know the Earnings Per Share formula.
There are two ways you can calculate EPS. The EPS formula are:
Weighted Earnings Per Share = (Net Income – Total Dividend)/Weighted Average Outstanding Shares for the period
The Earnings Per Share ratio is calculated by deducting net income from the total dividend and dividing this figure by the weighted average of shares the company has issued.
Let’s understand this with the help of an example.
A company ABC reported its net income for FY21 to be Rs.1 crore. After generating significant profit, the company paid dividends to its shareholders at the expense of Rs.10 lakh.
Assuming that the company has 10 lakh weighted average outstanding shares, the weighted EPS would be calculated as:
(Rs 1,00,00,000 – Rs 10,00,000 ) / 10,00,000
= 90,00,000 / 10,00,000
= Rs.9
Therefore, the weighted average earnings per share become Rs.9 per share.
Earnings Per Share = Net Income after Tax/Total Number of Outstanding Shares
Let us try to understand this with the help of an example:
If a Company XYZ reports that its net income after tax for FY21 was Rs.10 crore, and it has Rs.5 crore outstanding shares in the market, then the Earnings Per share will be calculated as:
10,00,00,000 / 5,00,00,000
= Rs 2/-
Therefore, the EPS becomes Rs. 2 per share.
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1. Reported EPS or GAAP EPS
It is accomplished using GAAP (Generally Accepted Accounting Principles). However, GAAP can affect a company’s earnings. For instance, if the income is generated by a one-time payment and treated as operating income under GAAP, the EPS may increase. Likewise, if a company considers significant ordinary expenses to be uncommon expenses, it would boost EPS artificially.
2. Ongoing EPS or Pro Forma EPS
Ongoing EPS or Pro Forma EPS considers the ordinary net income without considering any income resulting from a one-time event. As the word ‘pro forma’ suggests, certain assumptions have been made while calculating the EPS. This helps compute the company’s anticipated income from its primary business activities and not its actual earnings.
3. Retained EPS
As the name suggests, retained EPS means that the corporation keeps or retains the profit made instead of sharing it with the shareholders as dividends. The companies then use these earnings to pay existing debts, using them for business expansion, while some of it is set aside for future needs.
The retained EPS can be calculated by adding a company’s net and current retained earnings. This figure is then subtracted from the total amount of dividend that is paid to the shareholders. The remaining amount is then divided by the total number of outstanding shares.
4. Cash EPS
Cash EPS helps understand a company’s financial situation. It denotes the total cash earned by the company in a specified period. Manipulating the cash earning per share is very difficult.
You can calculate the Cash EPS by using the following formula:
Cash EPS = Operating Cash Flow/Diluted Shares Outstanding
5. Book Value EPS
Book value EPS is a static assessment of the company’s performance as its focus is on the balance sheet. It is used to obtain each share’s mean average amount of company equity. This also helps the company determine the value of its stake if it needs to be liquidated.
To compute the weighted average number of outstanding common shares, a company has to deduce the following:
Step 1: Determine the net profit reported by the company in the previous fiscal year
The easiest approach would be to use the company’s annual net earnings or net income, which is generally available on their website or on NSE/BSE. Pay attention to the report you analyse and do not get confused between quarterly net income with annual net income- you have to consider the annual net income.
The number of shares in circulation is the number of shares owned or held on the stock exchange by the corporation.
To determine the earnings per share ratio, divide last year’s net income by the total number of outstanding shares.
Earnings per share that are higher indicate that the company is making more profits that can be distributed to its investors. As a general principle, the higher EPS or earnings per share of a company can also attract a higher number of investors since it increases the chances of the company’s profit being translated into dividend payouts. This can result in the company’s stock price appreciation over time. However, do bear in mind that a higher EPS is not a measure of guaranteed future performance of the company.
Lower EPS or low earnings per share suggests that a company may have a low net profit and may be reluctant to share its earnings with its shareholders in the form of dividends. This may further lead to the company’s stock price decreasing or stagnating. It can also lead to fewer investors interested in the company’s stock.
The EPS ratio demonstrates the company’s profitability and is viewed as one of the key indicators of the company’s financial health. Companies post EPS ratio four times a year, once during the earnings in each quarter. This Earnings Per Share ratio reflects a company’s performance and underlines the company’s profitability quotient.
The EPS ratio can be useful while analysing or evaluating various stocks. EPS is one of the determinants of the Price-to-Earnings (PE) ratio that compares a company’s stock price to its earnings per share (EPS).
P/E ratio = Share price / EPS
If a company’s P/E ratio is higher than the average P/E ratio of that sector, it may be a sign that the company is overvalued or may be in the overbought zone. Conversely, if a company’s P/E ratio is less than the average P/E ratio of that sector, it may be a sign that the company has a great scope for investment and further growth.
When considering purchasing, selling, or holding a company’s shares, Earning Per Share ratio is a metric that is extremely important. Here’s how EPS can help investors make an informed choice when investing in a company’s stock:
- EPS helps determine a company’s financial performance and profitability.
- It helps understand a company’s financial performance and how it affects dividend payout.
- EPS is used to determine the company’s price-earnings ratio (P/E ratio), which compares the stock price to Earnings Per Share and estimates how a stock is valued amongst its peers.
- The metric is used to determine whether the company’s profits are increasing or decreasing over time.
- It can also be compared to the EPS ratios of other companies in its sector for analysts and investors to compare stocks.
Although Earning Per Share is very useful in determining the company’s profitability, it has certain limitations. Following are a few limitations that every investor and business owner should remember when using EPS:
- Companies can manipulate their Earnings Per Share to project their venture as a profitable one and make it more attractive to potential investors. This can be done by repurchasing shares or reducing the number of issued shares.
- The EPS does not take the actual share price of the company into account, so it may not help with stock evaluation for a company.
- A company may announce a stock split to make its stock more affordable to the masses. However, this will increase its issued shares in the market which can result in a drop in the EPS while the earnings of the company are not affected.
Basic EPS vs. Diluted EPS
Basic EPS is a metric to measure a company’s earnings on a per-share basis. Diluted EPS, on the other hand, is a metric fundamentally used as an analysis indicator to assess a company’s EPS quality after all convertible securities have been exchanged. Examples of convertible instruments include outstanding convertible preferred shares, stock options, convertible debt, and warrants.
Basic EPS, unlike diluted EPS, does not factor in the dilutive effects of convertible securities on EPS. Dilutive effects occur when the number of shares increases through any means. For example, if a corporation issues more shares to investors, the number of shares outstanding rises, lowering the company’s EPS. As a result, the stock price may face a decline in the market.
Here is how diluted EPS can be calculated:
Step 1: Subtract the company’s net income from dividends.
Step 2: Divide the result by the weighted average shares outstanding and dilutive shares including convertible securities.
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Final Word
The Earnings Per Share (EPS) ratio indicates whether a company’s profits are increasing or declining over time. The ratio cannot be overlooked because it helps to analyse the corporation’s past performance as well as the capacity of its competitors. Simply put, it is considered one of the important screening criteria when making investment decisions. However, you should not solely rely on the Earnings Per Share ratio, before considering possible investments, you should also examine future inflation estimates, interest rates, and the market mood.
FAQs
Ans: Earnings per share is a valuable metric for assessing a company’s financial condition and stock value (EPS). Earnings Per Share, or EPS helps determine business value. It is defined as the value of earnings per outstanding share of the company’s common stock.
Ans: The following are the components of EPS calculation:
• Net income
• Preferred income
• Total number of shares outstanding or weighted average shares outstanding
Ans: Earnings Per Share is important since it allows you to analyse the performance of prospective firms and choose the best investment option.
Ans: The diluted EPS is calculated by the formula mentioned below:
Diluted EPS=Net income/current shares outstanding+exercisable rights on new shares.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
