Cherry-picking the most feasible stock available to the investor from an ocean of options is a tricky affair. There are quite a few macro and micro factors that the investor needs to scrutinise, before diving right in the share market. Some of these factors include dividend yields, current economic and political conditions, monetary policies, trade relations, , price to earnings ratio, corporate actions like capital raising and mergers and acquisitions, and the list would go on. One of the key financial measures, that needs to be looked into is the Earnings Per Share of the company.
Understanding Earnings Per Share
In simple words, EPS, abbreviated for Earnings Per Share is the measure of profit that a company has generated and a representation of the portion of a company’s earnings. EPS is, hence, the monetary worth of earnings for every particular outstanding share of the stock of a firm.
It is a ratio and is also referred to as the net income per share, as it measures the amount of net income that has been earned through each share of the outstanding stock. The EPS is a direct indicator of a company’s financial health and is regarded as a vital variable in the determination of a stock’s value.
If one had to distribute the profits to the outstanding shares shareholders at the end of a year, the amount that each share of the stock would receive- would be the Earnings Per Share. The EPS depicts the profitability of the company on a stakeholder basis. The EPS is heavily dependent on the number of outstanding shares that the company trades with. Large companies divide their earnings per share among larger number of shares, as the number of outstanding shares for them is much more than the small companies, who have to divide the earnings per share to a lesser number of shares.
How can one calculate EPS?
The Earnings Per Share is calculated using the below given formula:
To derive the Earnings Per Share of a company, the balance sheet and income statement are used to decipher the number of common shares at the end of the period, dividends paid on any preferred stock and the net income or total earnings of the company.
At times, the weighted average number of shares is considered while calculating the EPS as the number of shares are prone to change over time, hence the method is appropriate in cases where the capital structure of the company would change during a reporting period.
Let us understand this, taking the example of metals and mining giant BHP Billiton Limited’s (ASX: BHP) Earnings Per Share for the quarter that ended in Dec. 2018. The company’s Net income for the quarter was A$3,764 million and it had 2659 million outstanding shares. Therefore, the diluted earnings per share of the company would be:
BHP’s EPS for 2018 December Quarter (Source: ASX)
What are the types of EPS?
There are three types of EPS, and this depends on the source of the data:
- Trailing EPS- refers to the EPS which is based on the numbers of the prior year.
- Current EPS- refers to the EPS of the current year’s numbers, as per forecasts.
- Forward EPS- refers to the EPS of the future numbers, as per expectations.
What is the importance of EPS?
EPS is considered to be an essential tool that aids market experts and participants to gauge the anticipated profitability a company could generate, before they go ahead and buy its shares. The knowledge of the company’s ability to generate net profit for its shareholders, is perhaps the most important feature that an EPS ratio delivers. Let us understand the reasons that make Earnings Per Share an essential financial ration considered in trading activities:
- Higher EPS indicates a healthy environment in which the company operates and its ability to pay more money to its shareholders.
- EPS comparison indicates the performance of the company, compared to other players in its competitive space.
- Past assessments and future anticipations of EPS contributes to the decision of investing.
- EPS is a significant element to derive other financial measures of the company, like the P/E ratio.
Does EPS have any limitations?
Now that we have established the importance of EPS in a trading business scenario, it is difficult to fathom its limitations. Having said so, EPS does not come with much drawbacks, but a few. Let us understand them:
- EPS cannot be the sole financial measure that an investor can rely on, before investing in a stock, as there are various factors that affect the dynamic nature of the business.
- Another limitation is that firms have the option to buy-back of their own shares and can reduce the number of outstanding shares, to improve the earnings per share- thus manipulating their audience in to believing that the company genuinely has a higher EPS.
- The EPS does not consider the factors like the outstanding debt.
- The EPS ratio does not consider the capital requirements to obtain the earnings.
Basic EPS vs Diluted EPS
Both these forms are profitability criteria used by a company. Both the methods aid companies in reporting the earnings that they generate, per-share. But there is a difference in the approach of these EPS metrics.
A basic EPS takes in account the business earnings of each share without delving deep into any other details. It merely uses the formula as discussed above, by dividing the number of outstanding equity shares with (net income – preferred dividend). It does not take the convertible securities into consideration, while calculating the profitability of the company.
On the other hand, as a more detailed and complex metrics, the Diluted EPS takes in consideration the convertible securities and then calculated the EPS. These include employment stock options, equity, debt, convertible preferred shares, etc, and exercises them. Hence, unlike just common shares in Basic EPS, diluted EPS includes preferred shares, stock options, debt, warrants, and other factors while calculating the profitability of the company. Let us revise the formula, to understand Diluted EPS better:
|Diluted EPS = Net Income- Dividends on Preferred stock Average Outstanding shares + Diluted shares|
What is EPS excluding Extraordinary Items?
Let us understand the meaning of Extraordinary items before linking EPS with it. Extraordinary items are those which are not frequent and are rarely seen, like a natural disaster or terrorist activity. These events are the ones that distort the EPS and could be both intentional and unintentional. In order to avoid misleading shareholders about these acts, the extraordinary items are regarded separately. The EPS, if applicable in the case of an Extraordinary Item, is calculated as under:
|EPS = Net Income- Preferred Dividends (+/-) Extraordinary Items Weighted average common shares|
What is EPS from Continuing Operations?
While the business functions, operations continue to take place, some are added, and others cease to exist. The company’s EPS from its day-to-day operations refers to as the EPS from Continuing Operations. This is non-inclusive of accounting changes, discontinued works and extraordinary items. The data is usually extracted from the company’s income reports and other public documents. The EPS from Continuing Operations is calculated using the below described formula:
|EPS = Net Income-Preferred Dividends (+/-) Extra Items (+/-) Discontinued Ops Weighted average common shares|
How are EPS and Capital related?
It is a fact that capital is the prime requisite to generate the earnings in the calculation. There could be companies that would be generating the same EPS, but with indifferent net assets. The company which would generate the same EPS, but with comparatively less assets is deemed to be utilising its capital more effectively to generate the income.
How are EPS and Dividend related?
Earnings per share and dividends per share depict the company's profitability. EPS showcases the profitability a company can get, using per share of its stock. Dividend per share is a measure of the company’s earnings that would be particularly rolled out to its stakeholders.
How are EPS and Price to Earnings related?
The Price to Earnings is another ratio, or a financial measure, which is used to understand the fundamentals of the performance of the stock of a company. The P/E ratio is heavily dependant and related to the EPS as it refers to the company’s present stock price, divided by the EPS. Therefore, if one is oblivious about the EPS, the basic derivation of P/E ratio cannot occur.
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