What is Earnings Per Share?
EPS is the per share profit by a business in a given period. While analysing a business financially, it serves as one of the basic tools. EPS is calculated by dividing profits by total shares outstanding for a given period.
EPS is reported on the profit and loss statement of an enterprise and works as a denominator for beloved price-to-earnings ratio (P/E ratio), used not just by novice investors but also fund managers. A business is required to generate sustainable earnings in its life cycle, and earnings or profits are essentially among major intend of a promotor.
To know more about P/E ratio read: Understanding Price-Earnings Ratio
But reported earnings of a business will likely differ from actual cash earnings because devising profits mandate broader accounting standards and principles to provide a fair picture of an enterprise. EPS, therefore, becomes imperative for investors, market participants and other users of information.
EPS estimates are circulated by sell-side analysts to market participants. Financial Modelling is applied to arrive at the EPS estimates of future financial years, semi-annual periods or quarterly, depending on the reporting adopted by the firm.
Analyst estimates are then collected by market data providers like Reuters, Bloomberg, IRESS to provide a consensus view of analysts on the business and its financials, including revenue, operating expense, earnings before interest and tax, profit after tax, EPS.
Market estimates enable participants to evaluate the expectations of sell-side analysts from a particular company, sector or even index. Analyst estimates also indicate the divergence between an individual’s expectations and collective expectations of analysts that are tracking the company.
An individual can, therefore, determine whether the stock of the company is undervalued or overpriced by the market against hi one’s fair value estimates that are based on the expectations from the company.
More on EPS read: What Do We Mean By Earnings Per Share (EPS)?
How to calculate EPS?
Although general formula considers total shares outstanding in the denominator, it is preferred to use weighted average shares outstanding over a period because companies issue new shares, buyback or cancel shares.
Net Income is the profit reported by a business after incurring income tax. It is also called as Net Profit After Tax.
Dividends on Preferred Shares are paid to preferential shareholders because they have first right over the income of a business, but preferred shares don’t have voting rights like common shareholders or ordinary shareholders.
Weighted Average Shares Outstanding is calculated after incorporating changes in number of shares during a period, and using weighted average shares outstanding provides a fair financial position of a company.
Basic V/S Diluted EPS
Diluted EPS is calculated after adding the weighted average number of shares that would be issued after the conversion of dilutive shares to weighted average shares outstanding. Dilutions can include share rights, performance rights, convertible bonds etc.
Whereas Basic EPS is calculated by taking weighted average shares outstanding that incorporate changes to number of shares outstanding such as buyback, new issues etc.
What is Adjusted-EPS?
In a financial period, firms may incur one-time expenses or transactions that are not usual in the normal course of business. The objective of adjusted EPS is to arrive at a fair picture of the business, especially for financial forecasting.
Extraordinary items are excluding from EPS to arrive at adjusted EPS figure. These items can include gain on sale of assets, loss on sale of assets, merger costs, capital raising costs, integration expenses etc.
What is Normalised EPS?
Normalised EPS is calculated to arrive at an EPS figure, which embeds the fluctuations in income due to business cycles or industry cycles. It also includes adjustments made for calculation of adjusted EPS such as one-time gains or losses.
Normalised EPS is a useful measure for companies that are sensitive to economic cycles or changes in the business environment. By smoothening out the fluctuations, it provides a fair picture of the business.
If a company has reported high normalised earnings over periods, it is considered that the company is less sensitive to changes in business cycles because of its stable revenues and income during the periods.
EPS and Price-to-earnings ratio
Calculation of price-to-earnings ratio requires EPS as denominator and price of the stock as numerator. EPS therefore becomes a very important financial metric for investors. EPS and price data also allows participants to compare the historical trends of the P/E ratio with the current market scenario and P/E ratio of the stock.
How can increase grow EPS?
Businesses can increase EPS by focusing on increasing their revenue, by improving operational efficiencies either by deploying technology to reduce cost, or negotiate better prices with vendors, operate in tax efficient manner, etc. Businesses can also improve EPS by undertaking corporate action such as buying back of shares.
What is an Absolute Advantage? Absolute advantage is one of the key macroeconomic terms, which is based on the principles of Capitalism and is often utilised in international trade-related decisions. Absolute advantage refers to the competence of a company, region or country to produce goods or services in an efficient manner compared to any other economic entity. The efficiency in production can be achieved by: Production of the same quantity of good or services as produced by other entity by utilising fewer amount of resources Production of a higher quantity of good or services as produced by other entity by using the same amount of resources What is the Significance of Absolute Advantage? Different countries or businesses possess a different set of ability owing to their location, soil composition, weather, infrastructure, or human resource skills. When applied in the right direction, various factors may pan out to offer more cost-effectiveness and hence build absolute advantage of the entity in comparison to others. The absolute advantage remains one of the critical determinants for the choice of the goods or services to be produced. Absolute advantage in a particular area often translates into profitability in the area. The profit margin increases by the achievement of cost efficiency, allowing the entity to ensure higher profitability over the competitors. For example, let us assume that the US can produce ten high-quality aircrafts utilising a specific amount of resources. China, on the other hand, can build 6 similar quality aircrafts using the same amount of resources. Thus, in the production of an aircraft, the US holds Absolute Advantage Let’s say the US has the ability to manufacture a certain amount of steel using 10 tonnes of iron ore. China, on the other hand, can produce the same quantity of steel using 8 tonnes of iron ore.Here, China here holds Absolute Advantage in the production of steel. How Countries Build Absolute Advantage? While natural conditions, which include climatic factors, geometry, topography, cannot be altered for achieving absolute advantage, the countries use the underlying factors strategically in their favour. Furthermore, factors of production are focused at by many companies or nations for building absolute advantages. Some of the strategies for building absolute advantage includes: Development of Technological Competencies- The implementation of innovative or latest technological innovations allows the entities to lower their production cost, facilitating absolute advantage. Enhancing Skills of Human Resources- The improvement in the cost-efficiency, along with the quality of the products, is targeted through imparting varying skill development programs. Many countries subsidize or aid the apprentice or labour training for enhancing the absolute advantage in trade. Improving Infrastructure- The infrastructure enhancement in the form of road, telecommunications, ports, etc. can be useful in enhancing the cost-effectiveness across different industries. What Do We Understand by Comparative Advantage Vs Absolute Advantage? Evaluating the comparative advantage introduces the concept of opportunity cost, which is the deciding factor to determine the production of particular goods or services. Opportunity cost refers to the potential benefits associated with the next best possible alternative which is missed out when one option is chosen over another. The Absolute advantage simply considers the capability of a business or region to deliver goods or services in the most efficient manner. The Comparative Advantage, however, also takes into account the benefits that are forgone if an entity decides for production of a particular product or services. Comparative advantage, based on the notion of mutual benefits, is often used in international trade deals. The Comparative advantage has been the major factor driving the outsourcing of services in search of cheap labour. Understanding through an Example For instance, country A can produce ten televisions with the same amount of resources with which it can make 7 laptops. The opportunity cost per television is 7/10 or 0.7 laptops. Meanwhile, the opportunity cost per laptop is 10/7 or 1.42 television. It highlights that country A is forsaking the production of 0.7 laptops if it is deciding to manufacture one television. On the other hand, it is missing out the opportunity to manufacture 1.42 televisions for every single laptop manufactured. Now, say Country B’s opportunity cost for producing a television is 0.5 laptop, and that of producing laptop is 2 televisions. Then, country B will have a comparative advantage in making televisions, and country A will have comparative advantage in producing laptops. It has to be noted that despite country A having absolute advantages in both the products, it would be mutually beneficial for both the countries if country B produces television while country A produces laptops. Do You Know About Absolute Advantage Theory by Adam Smith? The concept of Absolute Advantage was indicated by Adam Smith in his book called ‘Wealth of Nations’ which focusses on International trade theory. Adam Smith, in his book attacked on the previous mercantilism theory, which mainly stressed for economies to maintain trade surplus in order to command power. The Absolute Advantage theory considered that the countries possess different ability with respect to the production of varying goods or services. It argued that it is not necessary that a state may hold an absolute advantage in the production of all goods, and here the relevance of trade comes into play. It advocates that countries should produce those goods over which they hold a competitive advantage. It would allow the countries to make the same amount of goods using few resources or in less time. The theory propagates the relevance of trade for economic sustainability. What Are the Limitations of the Absolute Advantage Theory? The assumptions used in the Absolute Advantage Theory by Adam Smith may limit the application in real bilateral trade. The limitations of the theory by Adam Smith include: Smith assumed that the productive capabilities of a country could not be transferred between the two countries. However, in practical terms, the competitive scenario aids the nations to acquire new capabilities and acquire new resources, especially in the technological and human resource skill aspects. The two-country trade which was used as a basis for the theory does not consider the trade barriers levied. The present scenario, however, is strikingly dominated by trade wars between economies. Nations impose huge tariffs, import duties and other type of barriers to promote local manufacturers. Absolute Advantage theory assumes that the trade between the two nations will take place only if each of the two economies holds an absolute advantage in one of the commodities traded. However, in general, countries despite not holding absolute advantage are engrossed in international trade, boosting their economic setup.
Ability-to-Pay Taxation The neoteric trending concept in which the tax is levied as per the taxpayer’s economic ability to pay. It is based on the concept that a person who earns more should pay more taxes and the one earning less should pay less.
Gain or loss as a percentage of the initial capital invested. For example – If we gain $10 on investing $100, our Absolute return would be 10% ($10/$100*100)
Calculating the cost of a product or an enterprise based on the direct and the indirect costs (overheads) involved. Multiple methods of absorption costing include Direct labour cost percentage rate, Direct material cost percentage rate, Labour hour rate , Prime cost percentage rate and Machine hour rate.