Earnings per share (EPS) is a financial measurement that tells investors if a company is profitable. Savvy investors consider a company’s earnings per share when determining investment decisions. Understanding the calculation of earnings per share and how it plays a role in selecting a stock can help investors make smart money moves.
Earnings Per Share Explained
Earnings per share (EPS) indicates the financial health of a company. While earnings are a company’s revenue minus operation expenses, earnings per share are the earnings remaining for shareholders divided by the number of outstanding shares. If a company has high earnings per share, investors perceive them to be more profitable.
Many investors will use this number to gauge whether investing in a particular company is a savvy endeavor. The number becomes more valuable when investors evaluate a company’s EPS by comparing it with other companies in the same industry. They may also evaluate the company’s share price (price-earnings ratio) and market cap. Using a company’s EPS combined with share price helps investors decide if the stock is fairly priced or overpriced.
Evaluation During Earning Seasons
Federal securities law requires publicly traded companies to release their financial statements on an ongoing basis. Typically, companies will produce financial results quarterly. However, some follow a fiscal calendar.
Although analysts and investors review all financial results, EPS is one of the most critical evaluations during earnings season. Since investors prioritize earnings, stock analysts will formulate earnings estimates. The investors then collect all the estimates into what’s called the consensus earnings forecast.
If a company surpasses its estimate, it’s called earning surprise, which then may result in a spike to the stock price. But, if the company’s earnings are less than the estimate, the stock price tends to fall.
How to Calculate EPS
There are a couple of ways to calculate a company’s EPS. The first is to subtract preferred dividends from net income and divide by the end of period shares outstanding. The other way is to subtract preferred dividends from net income and divide by the weighted average shares outstanding. In basic practice, many investors use the first formula when calculating the dominator of the equation.
For example, Company XYZ has a net income of $2 million in the second quarter of 2019. The company then announced preferred dividends of $275,000, with the total number of shares outstanding being 12 million. Here’s how the equation looks:
EPS = ($2,000,000 – $275,000) / 12,000,000 = $0.14
Because common shares receive equal earning, each share would receive $0.14 or 14 cents.
Some investors and analysts use a diluted EPS because it understates the actual amount of EPS entitled to shareholders. This is because companies often have dilutive securities outstanding such as stock options that tend to increase the number of shares outstanding. Because converting options into outstanding shares raises the total number of outstanding shares without raising its net income, the EPS is dilutive.
For example, let’s say Company XYZ has stock options that can be converted into 2 million shares outstanding. If we add that to the 12 million shares outstanding, we have a total of 14 million. If we put that into the equation, we see that the dilutive EPS is $0.12 or 12 cents, which is less than the basic EPS of 14 cents.
An analyst may also use the normalized EPS. The normalized EPS intends to develop a more accurate portrayal of a company’s financial health. This adjustment of a company’s income statement reflects the cycles of the economy and one-off expenses that may not reliably reveal a company’s profitability.
The Importance of Evaluating EPS
Analysts and investors pay close attention to a company’s earnings because it can ultimately drive the stock price. Generally, if a company has strong earnings for a quarter, it’s a sign that the stock price may increase. Conversely, if earnings are dropping, this is a sign the stock price might decrease. Even if a company isn’t blowing its earnings out of the water, any increase can be a sign of future profitability. But since many factors play a role in this evaluation, investors can never guarantee this prediction will materialize.
For example, if you take a look back at the dot-com boom, earnings came in substantially less than investors predicted. Initially, investors felt excited about the potential growth of the companies involved, and that resulted in skyrocketing stock prices. Unfortunately, companies weren’t earning enough to keep up with the prediction, making it impossible to support their high valuations. This resulted in plummeting stock prices for these dot-com companies.
When companies make money, they can either invest their equity back into their company or pass it on to the shareholders with dividends or share buyback. While the first option may help the company increase profits, the second option lets shareholders make money right away. Ideally, both options will help the company increase earnings, resulting in returns for the investors.
The Bottom Line
Earnings per share is one of the key factors investors should use when determining the financial health of the company. If you’re considering the purchase of stock from a specific company, evaluating its earnings per share is one indicator that the company is heading in the right direction toward profitability. However, it’s important to be mindful that EPS may not tell the whole story. EPS can be manipulated by companies who buy back their own shares, and it doesn’t take outstanding debt into account. Before you purchase any stock in a company, make sure the investment aligns with your financial goals.
Tips for Investors
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