Get familiar with the basics of earnings per share (EPS) and what this profitability metric means for investors.
5 min read
Before they put their hard-earned cash into buying a company’s stock, investors want to know how profitable that company actually is. Obviously, no one wants to sink their money into a business that’s going nowhere. Enter: earnings per share (EPS), a measurement that can show how much profit each share makes.So, what exactly is EPS? And how is it calculated? This article breaks it all down, including the EPS formula, so that you’re more equipped to navigate your investment decisions.
What is EPS (earnings per share)?
First, a basic definition: Earnings per share (EPS) shows how much profit a company earns for each outstanding common share. When you divide net income by the number of shares, you get an idea of a company’s profitability. This is a key tool in comparing financial performance across different companies. With EPS, investors can measure profit, efficiency, and overall stock market competitiveness.
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There are two main ways to figure out earnings per share: basic EPS and diluted EPS. Both are important for understanding how a company is doing and for comparing it to other companies over time. Let’s zero in on both of these approaches.
Calculating the basic EPS formula
The basic EPS formula sounds wordy, but it’s not as complicated as it seems. A couple of quick refreshers: Dividends are a payout that a company can make to its shareholders. Weighted average shares outstanding is a detailed way of measuring how many shares exist for a given company during a period of time. First, subtract preferred dividends from net income. Then, divide by the weighted average number of shares outstanding. In mathematical terms, the formula is: (net income – preferred dividends) / weighted average shares outstanding = earnings per shareLet’s say a company has a net income of $100 million, pays out preferred dividends of $10 million, and has 50 million weighted average shares outstanding. The calculation would be: ($100 million – $10 million) / 50 million = $1.80 per shareThis means that each common share earns $1.80 in profit — so that’s the EPS.
How to calculate diluted EPS
Diluted EPS takes the basic calculation one step further. It accounts for potential shares from convertible securities, such as stock options or convertible bonds. By including additional shares that could be issued, this method gives a more conservative estimate of profitability. If we take the same company from the last example, but say that it has an extra five million convertible shares, the diluted EPS calculation will use a higher total share count. This gives us a lower EPS — approximately $1.64 per share.This approach is valuable because it shows how extra shares could impact profit. Even if those shares aren’t currently a factor, share dilution in the future could bring down EPS.
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EPS is important because it’s another way for investors to evaluate potential investments. There are two important things that EPS does:
EPS is an indicator of profitability
Again, EPS shows how much profit is generated for each outstanding common share, and that gives us an overall idea of a company’s profitability.For instance, let’s say we have an EPS benchmark of $2.50. An EPS that consistently sits around or above this level might be a sign of strong profitability, especially if the company is also showing steady growth over time. If a company’s management is effective at turning revenue into profit and sustaining a healthy bottom line, that success will show up in its EPS.
EPS is a great comparison tool
EPS also serves as an effective comparison tool within the same industry. Investors often use it to compare the profitability of similar companies, making it easier to identify which ones are financially stronger. Here’s an example: Company A reports an EPS of $3.00 while Company B shows $2.00, and other factors are staying consistent. From an investor’s perspective, Company A’s higher EPS might signal that they’re better at generating profits than Company B is.
What are the limitations of EPS?
Although EPS is a valuable metric, it’s not a full financial analysis on its own. Understanding the limitations of EPS helps investors use it thoughtfully and avoid potential risks. Here are two aspects that investors should keep an eye on:
Misleading accounting
EPS is based on company earnings — but some accounting practices might mask the true economic performance of a company. For instance, changes in depreciation methods, share buybacks, or one-time gains can artificially boost EPS. There could be underlying issues, so it’s important for investors to dig deeper into a company’s financial statements rather than relying solely on EPS.
Missing factors
EPS indicates how much a company earns per share, but that’s not the whole story. It doesn’t reflect things like how the company is funded, how well it runs, or how much it could grow in the future. Investors should also look at other numbers, such as sales trends, debt, and cash flow, to get a full picture of the company’s financial health.Ultimately, earnings per share can be a clear measure of a company's profitability, and it just takes a quick calculation. Still, it’s important to use EPS alongside other financial metrics for a more complete picture of a company's health. When investors use it wisely, EPS can be a helpful tool for making well-informed investment decisions.
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FAQs
EPS focuses specifically on how much profit each outstanding share earns. This makes it easier for investors to compare companies on a per-share basis. However, EPS is different from other metrics like net profit margin or return on equity. It doesn't take into account how efficient the company is or how much money it has, so it’s just one part of the financial picture.
Yes, a company's EPS can be negative. When a company loses money over a given period, the EPS calculation will be below zero. This shows that the company didn't generate a profit for its common shareholders during that time.
EPS is typically reported on a quarterly basis as part of a company’s earnings report. Investors can also find annual EPS figures, which give a big-picture view of a company’s profitability over a full financial year.
Several factors can influence EPS, including changes in net income, share buybacks, and share issuance through convertible securities. Also, things like adjustments in accounting practices, seasonal business trends, and one-off events can also affect EPS.
Generally, a higher EPS is a sign that a company is more profitable on a per-share basis. But it isn't always a definitive indicator of financial health. Share buybacks or other accounting adjustments might artificially cause a higher EPS. Looking at other financial metrics can help investors get a sense of a company’s overall performance.
