What is Earnings Per Share (EPS)?

Earnings per share (EPS) shows how much profit a company makes for each share of its stock. Investors use EPS to gauge a company's profitability and potential returns. High EPS suggests good profit-making potential and efficient use of investor funds.

To calculate EPS, subtract preferred dividends from net income, then divide by outstanding shares. Net income is what's left after deducting all expenses. Understanding EPS helps investors assess investment value and compare companies effectively.

What is Earnings Per Share (EPS)?

Earnings per share (EPS) is determined by dividing the net earnings available to the shareholders by the average outstanding shares. The earnings per share formula is used to determine a company's ability to generate profits for its shareholders. In this guide, we break down the Earnings per Share meaning and formula in detail.

EPS values are somewhat arbitrary for a single company. The number is more valuable than other companies within the same industry, and to the company's stock price (the P/E Ratio). When two companies have the same number of shares outstanding but have varying EPS, higher EPS indicates higher profitability. A company's earnings per share are typically compared with its share price to determine how cheap or expensive it is (low or high P/E ratio).

Formula and Calculation for EPS

Now that we know what is EPS in the share market, let’s learn how it's calculated.

The following are two formulas for determining EPS:

EPS = (Net Income –  Preferred Dividends) / Shares Outstanding at the end of the period

and 

EPS = (Net Income – Preferred Dividends) / Weighted Average Shares Outstanding

EPS is calculated using the total number of outstanding shares, but analysts often use the weighted average number of outstanding shares when calculating the denominator. Companies may issue stock throughout the year and this makes it difficult to determine the true outstanding shares and earnings per share. Therefore, we commonly use an average number. By measuring average outstanding shares, you can accurately determine a company's earnings.
 

Example of EPS

Having learned the earnings per share definition and formula, consider the following scenario for calculating earnings per share (EPS) for three companies:

Types of Earnings Per Share

Reported EPS or GAAP EPS: This type of EPS adheres to Generally Accepted Accounting Principles (GAAP) and is disclosed in SEC filings. However, GAAP can distort a company's earnings. For instance, if a one-time payment is categorized as operating income under GAAP, it could artificially inflate EPS. Similarly, if regular expenses are labeled as unusual, it can boost EPS artificially.

Ongoing EPS or Pro Forma EPS: This EPS is based on ordinary net income and excludes income that is typically categorized as unusual or one-time. Thus, it helps uncover anticipated income from core business operations but may not accurately reflect a company's true earnings.

Retained EPS: Retained EPS indicates that a company retains its profits instead of distributing them as dividends to shareholders. Many business owners utilize retained earnings per share to settle existing debts, fund expansion, or reserve funds for future needs. The calculation involves adding net earnings to current retained earnings, subtracting total dividends paid, and dividing the remainder by the total number of outstanding shares.

Cash EPS: Cash EPS provides insight into a company's financial health by revealing the exact amount of cash earned. It is challenging to manipulate and is calculated as Operating Cash Flow divided by Diluted Shares Outstanding.

Book Value EPS: This EPS calculates the average equity per share, offering an estimate of a company's stake value in case of liquidation. It provides a static representation of a company's performance as it focuses on the balance sheet.

Each type of EPS offers unique insights into a company's financial performance and is valuable for investors seeking to understand various aspects of a company's earnings and financial standing.

Importance of EPS

Earnings Per Share (EPS) holds immense importance for investors, offering a direct glimpse into a company's profitability. A higher EPS signifies greater profitability, rendering the company's stock more appealing to investors and often leading to higher stock valuations. Moreover, EPS plays a pivotal role in determining a company's stock price, with stocks boasting higher EPS typically commanding higher prices in the market.

Additionally, EPS serves as a valuable tool for investors to compare the profitability of different companies, aiding in informed decisions regarding portfolio diversification. Nonetheless, it's crucial for investors to complement EPS analysis with other financial indicators to gain a comprehensive understanding of a company's financial well-being.

Limitations of EPS

Earnings Per Share (EPS) has its limitations. It offers a snapshot of a company's profitability for a specific period, like a quarter or year, but doesn't show if profits are increasing or decreasing over time. It might not fully reflect a company's cash flow as EPS calculation includes non-cash expenses like depreciation. Thus, a company could be generating more cash than EPS suggests.

Moreover, companies can manipulate EPS by changing the number of shares outstanding through actions like share issuances or buybacks. While stock buybacks may boost EPS by reducing shares, it could also impact cash reserves and future investments. Share issuance and stock splits might dilute EPS, affecting its reliability as a measure of profitability. Investors should consider these factors alongside EPS for a clearer understanding of a company's financial health.

Diluted EPS vs. Basic EPS

There are similarities between basic and diluted earnings per share (EPS), but they are different concepts. Divide a company's profit or income by the number of outstanding shares to calculate basic EPS. In calculating diluted earnings per share, we consider all possible dilutions, such as when convertible securities are exercised or options are converted into shares.

We should use the diluted earnings per share method when valuing a company if the company is expected to undergo significant dilution due to employee stock options or similar actions. Other than that, basic earnings per share are sufficient for estimating future cash flows.

The following hypothetical example illustrates how basic EPS differs from diluted EPS when calculating investor value. We will use the scenario where someone owns one share of Company X, which had a net profit of Rs. 1 crore in its first year and did not need any additional debt or equity financing.

Assume that there are 100 shares outstanding and that the price per share is Rs. 10. Let's ignore dividends and taxes for simplicity's sake. In year 2, 50 employees get stock options at Rs. 5 per share. Moreover, 10 shares of employee stock were purchased for Rs. 7 each to reduce risk by diversifying among all employees.

Net income increased by 10% due to these actions, while all 110 potential shares were diluted by 5%. In this case, you will get Rs.0.91 per share instead of Rs.0.95 if you divide earnings by basic EPS rather than diluted EPS.

As an investor, both types of earnings per share are useful because they provide different perspectives on the value of a company based on the outlook for the future.

Adjusted EPS v/s EPS

Adjusted EPS is the earnings per share calculated based on a company's net earnings after removing the impact of one-time or non-recurring items. Basic EPS can be misleading if influenced by such items, like a one-time asset sale, leading to inflated or deflated net income.

Adjusted EPS focuses on the core operations' profitability, providing a more accurate picture for analyzing future returns. By adjusting the numerator of basic EPS, non-core profits and losses are eliminated, offering a normalized basis for evaluation. While recommended for disclosure in India, companies aren't obligated to report adjusted EPS, despite its value in assessing a company's true financial performance.

Conclusion

Indian Accounting Standard 33 provides guidelines for computing and disclosing Earnings Per Share (EPS) in a company's financial statements. EPS, DEPS, and Adjusted EPS help gauge a company's ability to generate returns for shareholders. Investors should consider multiple financial parameters to assess a company's merit as an investment option, ensuring a comprehensive understanding of its scope, profitability, and performance.