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In what follows, we are explaining why and how earnings per share (EPS) are calculated. As EPS is a widely used metric for estimating corporate value, understanding this concept is useful and important. In investors’ eyes, a higher EPS indicates a larger value: they will pay more for a company’s shares if they think the company has higher profits relative to its share price.
What Is Earnings Per Share (EPS)?
Earnings per share (EPS) is calculated as follows: a company’s profit gets divided by the outstanding shares of its common stock. The number that you get by these calculations shows how profitable a company is. The higher a company’s EPS, the more profitable it is thought to be.
How Is EPS Calculated?
Earnings per share value are calculated as net income, i.e. profits or earnings, divided by available shares. If you want to make a more refined calculation, adjust the numerator and denominator for shares that could be created through options, convertible debt, or warrants. Note also that the numerator of the equation is also more relevant if it is adjusted for continuing operations.
When you want to calculate a company’s EPS, you need to obtain its balance sheet and income statement. Use them to find the period-end number of common shares, dividends paid on preferred stocks, if they exist, and the net income or earnings. But note that your calculations will be more precise if you use a weighted average number of common shares over the reporting term because the number of shares can change over time.
Remember to include in the calculation of the weighted average number of shares outstanding any stock dividends or splits. You may also simplify the calculation by using the number of shares outstanding at the end of a period.
How Is EPS Used?
You cannot determine a company’s profitability on an absolute basis without EPS. It is one of the most important metrics employed in determining how much the company is worth. EPS is also an important component of calculating the price-to-earnings (P/E) valuation ratio. “E” in “P/E” is EPS. When you divide a firm’s share price by its earnings per share, you will see how much the market is willing to pay for each dollar of its earnings.
EPS is also useful if you are looking to choose stocks in which to invest. Interactive Traders can help you choose stocks with high EPS and explain how to invest in them. We will show you how to compare EPS with the share price of the stock so that you can determine the value of earnings with precision and gauge how investors feel about your chosen stock’s future growth.
What Is the Difference between Diluted EPS and Basic EPS?
Basic EPS is the company’s net income divided by its outstanding shares. When you read about companies’ profits, this is the figure you usually see in reports about them. As its name suggests, basic EPS is the simplest definition of EPS. Diluted EPS, by contrast, includes a more complex definition of the company’s shares outstanding. Diluted EPS is, therefore, is lower than or equal to the basic EPS. Diluted EPS includes shares that are not presently outstanding but can be so if stock options and other convertible securities are exercised.
What Is the Difference between EPS and adjusted EPS?
As its name suggests, adjusted EPS is a type of EPS calculation in which the analyst makes some adjustments to the numerator. Usually, analysts would add or remove components of net income considered non-recurring. Suppose a company’s net income grew because of one single successful sale. In this case, analysts, seeing that the sale was not recurring, might deduct the proceeds from this sale and, in doing so, make the company’s net income smaller. If this happens, adjusted EPS would be lower than basic EPS.
Some Limitations of EPS
There is a caveat when you look at EPS to make an investment: this measure has drawbacks. There are certain ways to play with EPS: companies buy back stocks, reduce the number of shares outstanding, and even increase the EPS number, even though the level of earnings remains the same. Also, note that EPS does not take into account the price of the share. Hence, by looking at EPS, you cannot understand whether a company’s stock is overvalued or undervalued.