Last Updated on May 25, 2022 by Neera Bhardwaj
A company listed on the stock exchange aims to maximise its profits to keep its shareholders happy. A company delivering high profits is seen as a stable organisation with the potential to grow and enjoys a high share price on the exchange.
However, when analysing the financial fundamentals of a company, only looking at the profit earned, in its simplest form, does not depict the company’s true financial health, and potential for future growth. Investors should also look at how this earning translates to each share they own. This is where the concept of earnings per share comes into the picture. Let’s understand.
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What is earnings per share?
Earnings Per Share, also known as EPS, in short, is the profit earned by a company per unit of its outstanding shares. Let’s simplify.
Say a company has issued 1 lakh shares on the stock exchange. In a quarter if the company earns a profit of Rs 5 lakh, the Earnings Per Share would be Rs 5, i.e. the company earned Rs 5 for each share that it has issued.
What is the importance of EPS?
EPS is a very important figure used by analysts and investors alike to fundamentally analyze a company. Here are some significant insights that EPS can give:
- Comparison across companies: EPS allows investors to not only compare companies in the same sector but also across all market capitalisations. Large-cap companies can earn higher profits compared to mid or small-cap companies. As such, checking only the profit figure in isolation does not give the real earnings potential of the company. However, with the EPS calculation, it becomes easy to find out the earnings generated by a company per share issued. This helps investors find out which company is more profitable for its shareholders compared to another.
- Aids fundamental analysis: EPS calculation also helps analysts conduct a fundamental analysis of companies. A company with a higher EPS is considered to be more profitable and financially sound. Analysts use EPS as the determining factor of a company’s financial health. It is, often, termed as the bottom line of a company’s worth.
- Determination of the value of the stock: Investors use the price-earnings ratio (P/E ratio) to determine whether a stock is appropriately valued vis-a-vis its earnings. EPS forms an integral part of the calculation of the P/E ratio. Thus, EPS can help investors assess the value of the stock that they want to invest in by helping them calculate the P/E ratio.
- Indicates potential dividend payouts: After retaining a part of their profits, companies usually pay out dividends to their shareholders. This dividend payment is directly linked to the EPS. If the EPS is high, the dividend is expected to be higher and vice-versa. Though a high EPS does not guarantee a high dividend payout (as companies might retain a major part of their profits), it does give an idea about the potential dividends that investors can expect. A company whose EPS increases consistently is expected to increase its dividend payouts too.
To calculate the EPS of an organisation, the EPS formula is used. This EPS formula is pretty straightforward considering the definition of the word itself.
The Earnings Per Share formula is as follows:
EPS = net income or profit / average outstanding common stock
However, if the organisation has issued preference shares too, the EPS formula would be tweaked. In such cases, the Earnings Per Share formula would be as follows:
EPS = (net income or profit – preference dividends) / average outstanding common stock
Let’s understand with a few examples. Consider the following:
|Total number of common stock issued
|Net profit earned by the company
|Rs 5 lakh
|Rs 5 lakh / Rs 10 lakh = Rs 0.50
Now, if you consider that the company had a preference stock of 1 lakh shares, the calculation would change. It would be as follows:
|Total number of outstanding stock
|Less: Preference stock
|Total number of common stock
|Net profit earned by the company
|Rs 5 lakh
|Less: Dividend paid on preference stock
|Rs 0.75 lakh
|Profit after paying dividend
|Rs 4.25 lakh
|Rs 4.25 lakh / 9 lakh= ~Rs 0.47
In some cases, the number of stocks at the end of the accounting period is used while in some cases, the weighted average number of stocks might be used when calculating the EPS.
The concept of diluted and adjusted EPS
In many cases, you might come across the terms diluted EPS and adjusted EPS. Here’s a quick look into what they mean:
- Diluted EPS: Diluted EPS is calculated after considering the convertible debts, options and outstanding warrants that an organisation might have. Since these can affect the outstanding stock when exercised, they might be included in determining the outstanding stock and so, the EPS reduces. This reduced EPS is called the diluted EPS.
- Adjusted EPS: Adjusted EPS, on the other hand, changes the numerator, i.e. the profit amount. In calculating the adjusted EPS, the profit or losses arising out of non-core activities of the organisation are removed. Only the core operating profit is considered in the calculation of the adjusted EPS.
Types of EPS
3 main types of EPS are calculated. These are as follows:
- Current EPS: This calculates the EPS of the current financial year. Every company issues four quarterly results every year. In the current EPS, the declared, as well as the projected earnings of the company, are used to calculate the EPS.
- Trailing EPS: As the name suggests, this is the EPS of the past. The earnings of the four quarters of the last financial year are used to calculate this EPS. Trailing EPS is the most commonly used mode of calculating the EPS ratio and shows the accurate figure.
- Forward EPS:This EPS looks to the future. The projected profits of the next financial year’s quarters are considered. This EPS is, thus, the potential EPS based on projected figures. This is commonly used by investors as it determines the future profit potential of the stock. Forward EPS is, usually, calculated either by experienced analysts or by the company itself.
To sum it up
EPS is an important parameter when picking the right stocks to invest in. It gives you an idea of the profitability of a company vis-a-vis the stocks it has issued. A higher EPS is favourable as it increases the dividend potential and also makes the company financially sound. So, when investing, compare between the EPS of different companies and then pick a company with a higher EPS ratio for maximum gains.