What is Earnings Per Share?
Definition: Earnings per share (EPS) are the amount of profit of a publicly-traded company per share of its outstanding stock. Essentially it is how much each outstanding share will be allocated if the company were to distribute its profits equally to its outstanding shares annually. This measure is used as a profitability benchmark for a company that informs investors on whether investing in the company could be a sound decision.
EPS tells us how profitable the company is relative to the number of its stockholders and profits per share. This measure is among the variables used in determining the share price of a company. It makes it possible to compare a smaller company’s earnings per share to a large company and the value depends greatly on the number of outstanding shares of the company.
This means that a large company will have to divide the earnings among many shareholders relative to a small company with few stockholders. If the company’s EPS is high then it implies that it is profitable and the amounts of earnings each shareholder will earn are more.
EPS is determined by taking the annual or quarterly net income of the company and then dividing it by the company’s total outstanding shares. Usually, if a company pays dividends they will be deducted from the profit or net income before calculating EPS.
The earnings per share formula is calculated by dividing the difference of net revenues and dividends by the total outstanding shares. The EPS equation looks like this:
It’s important to note that dividends are always subtracted from net income in order to calculate EPS. This is because earnings per share measures the income that will be available to common stock shareholders. The dividends in this case are preferred dividends meant for preferred shareholders.
Also, the weighted average of outstanding common shares is used in the formula because since EPS is calculated at the end of the financial year the company might have issued new stock or bought back some treasury stock over the year. The average can be easily be calculated by getting the sum of the beginning and closing outstanding common shares and then divide by two.
Investors always prefer companies with a high EPS because it shows how profitable the company is. This is because the EPS value indicates how healthy a company is in terms of finances for reinvesting as well as sharing with shareholders as dividends. Although most investors might not be keen on EPS, it’s important to understand that a higher EPS ratio often dictates the company’s share price. Investors don’t base their investment decisions based on EPS because there are a lot of things that can manipulate the ratio.
Besides being used in determining the profitability of a company the ratio is very important in informing potential investors if the company would increase dividends. Therefore from the ratio, you can quickly calculate the net income of the company, preferred dividends, and the average outstanding common shares. A combination of the figures can indicate if the company is in a growth path and where it can increase its earnings per share.
Limitations of EPS Analysis
Interestingly like most financial measures this ratio has its limitations also. For instance, their ratio is prone to manipulation whereby a company can engage in buying back its shares so that they can enhance the earnings per share value. This can be misleading as it will appear like the company is profitable yet in real sense it is not.
Also, the other limitation is that the calculation of earnings per share does not include the outstanding debt of the company. This is because should the company move to pay off the debt the EPS ratio will decrease significantly.
Summary
EPS is a very important metric in measuring a company’s profitability relative to the number of outstanding common shares. Most importantly a high EPS is an indication of the company’s profitability and would likely attract more investment.