Definition
Earnings Per Share (EPS) is a financial metric used to gauge a company’s profitability relative to the number of shares outstanding. It is calculated by dividing the company’s net earnings by its total number of shares. EPS is a critical indicator for investors, as it helps them understand how much profit a company generates per share of its stock.
What is EPS (earnings per share)?
EPS represents the portion of a company’s profit allocated to each outstanding share of common stock. It serves as an indicator of a company’s profitability. It is often used by analysts and investors to assess corporate value.
Imagine a pizza divided into ten slices. If the whole pizza represents a company’s total profit, EPS tells you how much profit each slice (share) represents.
How is EPS calculated?
The formula for EPS is:
EPS = Net income – Dividends on preferred stock/Average outstanding shares
This calculation provides the earnings yielded per share of stock, offering insight into company performance.
Net income, also known as net profit, is the company’s total earnings after accounting for all expenses, including taxes and operational costs. It represents the actual profit that is either reinvested in the business or distributed to shareholders.
Preferred stock is a type of stock that typically offers a fixed dividend and has priority over common stock in dividend payments and during liquidation.
For instance, if a company like Tesco reports a net income of £500 million after the dividends on preferred stock have been subtracted and has 250 million shares outstanding, its EPS would be £2 per share. This simple calculation gives investors a quick snapshot of Tesco’s profitability on a per-share basis.
Types of EPS: basic v diluted
- Basic EPS doesn’t account for any potential share dilution and is calculated using the current number of outstanding shares. For example, a company has 100 shares and no plans to issue more.
- Diluted EPS considers the impact of additional shares that could be created through options, convertible securities, or other potential shares. If the company might give out 20 more shares in the future (through options, for example), it calculates EPS as if there were 120 shares, not 100.
The significance of EPS in stock valuation
EPS is a valuable tool in the valuation of stocks. A higher EPS indicates greater profitability and often translates to a higher stock price. Investors typically compare the EPS of different companies in the same industry to gauge which business performs better. Suppose Company A has an EPS of £5 and Company B has an EPS of £3. Investors might view Company A as more profitable and valuable in that case.
Look at a major company’s quarterly or annual earnings report. They usually highlight EPS, showing whether it met, exceeded, or fell short of market expectations. For instance, tech giants like Apple or Amazon often make headlines with their earnings reports, including their EPS figures.
Furthermore, notice how the stock market reacts to EPS announcements. A higher-than-expected EPS can lead to a stock price surge, while a lower-than-expected EPS might cause a stock price to drop. This is evident in the stock market fluctuations following big earnings announcements from companies like Microsoft or Barclays.
Limitations of EPS as an investment metric
While EPS is helpful, it has limitations. It doesn’t account for the capital needed to generate the earnings (like debt or equity) and can be manipulated through accounting practices. So, it’s essential to look at other financial aspects too.
For example, a company might report a high EPS by reducing the number of shares through buybacks (when it buys its own shares from the stock market, reducing the number available to the public), but this doesn’t necessarily mean the company’s overall profitability has improved.
EPS in context: comparing companies
When comparing companies with EPS, it’s crucial to consider the context. For instance, companies in different industries or stages of growth may have varying EPS figures. Also, a company with a high EPS may not be a better investment if the stock price is disproportionately high. For example, comparing the EPS of a tech start-up with an established retail chain can be misleading due to different industry standards and growth stages.
Conclusion
EPS is a critical barometer of a company’s financial health, offering investors a valuable tool for making informed decisions. However, it’s important to remember that EPS is just one piece of the puzzle.
Astute investors should also consider other financial metrics such as P/E ratios, company debt levels, and market trends, as well as qualitative factors like company management and industry position.
By taking a holistic approach to investment analysis, you can more accurately gauge a company’s value and growth potential.
