Earnings Per Share (EPS) Explained

By: Rupesh Oli

What is EPS?

Earnings Per Share (EPS) is a financial metric that indicates the profitability of a company. It is among those indicators that investors/traders frequently take into usage to gauge the profitability before buying the stocks of the companies/businesses they are going to invest in. It is the ratio of a company’s net income to the number of shares outstanding, and used to track the performance of the company be it on an annual or quarterly basis, or to determine a company’s relative strength to the others. When performing the company’s comparison based on EPS, it is significant that investors/traders need to compare the companies that fall under the same sector/industry as the industry’s average EPS varies. For instance, the microfinance sector might possess higher or lower average EPS compared to the hydropower sector.

EPS denotes the company’s ability to generate profits for its shareholders. If a company depicts high EPS, each stock possesses the higher potential to generate returns for the investors/shareholders and vice-versa. As per William J. O’Neil, “Strong earnings growth is essential to a stock’s success and has the greatest impact on its future price performance.” EPS is used during the calculation of one of the crucial financial metrics, the P/E ratio. A company with higher EPS either pays ample dividend for the investors or utilizes the hefty income generated back into its business for further growth, either way, it indicates a worthwhile investment for the investors.

EPS to be used as a single indicator is not recommended before delving down into any sort of investment, hence, investors can use other metrics like P/E ratio, P/B ratio, PEG ratio, and so on, to gain more valuable and decisive insights regarding the company.

If the EPS of a company is $10 per share, it implies that if that particular company decides to pay the income earned, then the shareholders will be receiving $10 for each share they own.

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How to Calculate EPS?

To calculate the EPS of any company, you need to subtract dividend payments to the preferred stocks from net income after tax and divide the numerator by the average number of common shares outstanding (the denominator) during the measurement period. To calculate the EPS of any company, you can refer to the income statement and balance sheet for required data to input into the numerator and the denominator.

EPS = (Net Income After Tax – Preferred Stock Dividends) / Average Number of Common Shares Outstanding

Note: Preferred Stock is different from common stock. It is because preferred stockholders have a higher claim when it comes to dividends or asset distribution if compared to the common stockholders. Preferred stock dividends are paid out to the shareholders before the issue of common stock dividends. Out of nowhere, if the company goes bankrupt, preferred stockholders are entitled to be paid from the company assets before the common stockholders.

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Example of EPS

Suppose a company named XYZ has $4,000,000 as net income after tax and has to pay $400,000 as preferred stock dividends. If the company is found to have 600,000 shares as average common shares outstanding, XYZ’s earnings per share would be:

($4,000,000 – $400,000) / 600,000

= $ 6 per share

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Analysis Based on EPS

EPS is one of the very critical financial ratios when analyzing a company’s fundamentals. It helps investors identify the value of the company based on its stocks and gauge the probable growth prospect of that particular company or business. Higher EPS is always better than the lower one, as it indicates that the company is more profitable and possesses the capability to distribute higher dividends to its shareholders. Higher EPS of a company often leads its stock price to rise as the investors prefer the company with high EPS as it falls under one of their many criteria to evaluate the financial performance. However, investors need to consider that EPS can be manipulated by many other factors, hence they need to take it as an indicator to measure the company’s performance rather than solely depending on it and be drastically influenced to take the investment decisions.

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Types of EPS

Trailing EPS

Trailing EPS is based on the previous year’s number as the earnings from the previous four quarters are used when calculating EPS. As it is calculated on the basis of actual figures, the majority of stock value uses trailing EPS to convey its contemporary financial status to investors/traders; however, it represents what actually happened, not what will happen. Hence, it lacks the projection of future EPS.

Current EPS

Current EPS is based on figures from the four quarters of the current fiscal year. Some of the quarters may have already elapsed, while some yet to come. Hence, current EPS takes into consideration both the actual figures of the elapsed quarters and the projections for the upcoming ones.

Forward EPS

Forward EPS is calculated based on future projections, usually the coming four quarters. Analysts or the company itself do the estimation for forward EPS. When comparing with trailing and current EPS, forward EPS is a more interesting one as it is based on estimates. Since the investment is actually done relying on the company’s possible future earning potential, forward EPS is something that an investor should not miss out on.

Note: Make sure you compare all these three types of EPS ratios for a fruitful investment decision. For instance, if you compared the forward EPS with the current EPS of the company and found out that actual EPS lags, it is a strong indicator for the stock price to fall. On the contrary, if actual EPS blows forward EPS, it may be potentially referring towards the stock price to rise in coming days.

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Variations of EPS

Variations	What does it signify?
GAAP EPS	Also known as Reported EPS, GAAP EPS is calculated as per Generally Accepted Accounting Principles.
Pro Forma EPS	Also called Ongoing EPS, excludes unusual one-time income in the net income.
Retained EPS	Firstly, the sum of net earnings and current earnings is calculated, and the paid dividends are subtracted from the sum obtained, further divided by the total number of shares outstanding.
Cash EPS	The total operating cash flow of the company is divided by diluted shares outstanding.
Book Value EPS	Mainly focuses on the current balance sheet of the company when computing EPS.

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Basic EPS vs Diluted EPS: What’s the difference?

Basic EPS is the plainest form of EPS which is the most commonly reported EPS in financial portals and calculated simply by dividing the company’s net income by the total number of shares outstanding; however, diluted EPS is not the same as basic EPS. It is because diluted EPS is the lowest possible EPS that could be calculated as if all the convertible securities of the company become the outstanding shares. The financial instruments often used to raise the capital and motivate the employees in the company such as employee stock options and convertible debt need to be added to the count of shares outstanding in order to calculate the company’s diluted EPS. Hence, it would ultimately increase the value of the denominator lowering down the EPS. Diluted EPS are considered to be the conservative financial metric as it indicates the worst-case scenario in terms of the EPS of a company.

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EPS and Dividends

It is obvious that shareholders would not have direct access to the company’s profit. It is therefore a portion of the company’s earnings are distributed in the form of dividends. As EPS might be directly proportional to the dividends shareholders would be receiving as higher EPS denotes the company being highly profitable; however, it is not always the case. The company might also retain the earnings for its future growth and expansion. Hence, higher EPS might not necessarily indicate higher dividends. Nevertheless, EPS is one of the most used financial metrics to gauge the company’s dividend distributing capability.

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What is a good EPS?

EPS, whether it be good or bad, is dependent on various factors. Firstly, the industry average can be taken into account when determining whether a company’s EPS you are going to invest in, is up to the mark or not. If a company’s EPS is above the industry standard, it refers that a particular company is performing better than the ones with low EPS than the industry’s average. Secondly, you can perform the competitor’s analysis and determine whether the company that falls under the same sector/industry has better EPS than the company you selected.

In some cases, the company’s EPS and stock price might not align with each other. It is because of the investor’s expectation regarding the company’s performance in the coming days despite the satisfactory EPS. However, in the majority of cases, EPS and stock price go hand in hand with each other as a company with good EPS, implying better EPS than the competitors and the industry average, leads to a rise in the stock price of the company.

Thirdly, you can compare with the company’s EPS itself to determine the level of progress it has been showing over the years. You can measure EPS based on a year-to-year or quarter-to-quarter growth basis. Hence, before claiming the company possesses good EPS or not, various factors need to be analyzed before reaching the investment conclusion.

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What does Negative EPS signify?

A negative EPS basically refers to the negative net income of the company. Generally, negative EPS is not a good indicator for any company. However, for newer businesses such as startups might not be necessarily bad as they need to raise funding in their initial stage, and it takes time for them to actually start generating revenue and ultimately the positive net profit. If a newbie business has great prospects to become profitable in the foreseeable future, then it might be a worthwhile investment despite its negative EPS. On the contrary, if the matured business that delivered positive earnings in the past starts delivering negative earnings, it might be a signal of a caveat for the investors as it indicates the company is possibly losing the market share and on the verge of failure.

In the case of Nepal, Upper Tamakoshi Hydropower can be taken as a perfect example to depict investment in a company can be a good decision despite the negative EPS. Upper Tamakoshi was not able to generate net profit for the last two years and had delivered net loss in its last eight quarters. However, the company reported a whopping Rs. 860.01 million net profit in Q1 of 2078/79. It is for the first time that Upper Tamakoshi reported the net profit as it has now finally gone into its full operation with the project capacity of 456 MW, and it also sold electricity worth Rs. 1.72 Arba in the same quarter.

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Significance of EPS

• It eases you in picking up the fruitful investment option as you can compare the performance of the different companies and come up with the one that possesses stronger EPS than the others.

• It helps you to find out the company with higher dividend payout capability as the one with higher EPS refers to a highly profitable company.

• Not only can you measure the company’s current financial status, but you also can easily measure the company with its past performance and future estimation on the basis of trailing EPS and forward EPS respectively.

• It is one of the best financial indicators to use along with the P/E ratio to discover both value stocks as well as growth stocks.

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Limitations of EPS

• EPS does not take into consideration the stock price of a company, hence does not depict whether the company’s stock is trading above or below the fair value.

• The growth indicated by EPS might not be accurate as it does not consider inflation. With inflation, the overall prices of goods and services that a consumer consumes incline too.

• EPS may not accurately signify the company’s financial health as cash flow is not considered during the calculation of EPS. Further, cash flow is an important financial metric to measure a company’s ability to repay its debt, hence higher EPS might turn out ineffective when investors try to measure the company’s solvency.

• The different business possesses different non-operating expenses such as tax and interest payment which ultimately impact the net income of the business/company.

• A company might manipulate the total number of shares outstanding if factors such as share issuance, splits and stock buybacks are to be considered.

• The accounting and reporting procedures vary as per the company. Hence, changes to accounting policy for the reported earnings can impact the EPS of the company.

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