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Earnings per Share
Earnings per share is the net income made per share of stock within a given time period, typically quarterly or annually. To determine the EPS, the company's net profits are divided by the number of common stock shares it has outstanding.
Earnings per share is an important financial metric used to indicate a company's profitability. Often, when investors plan to invest in the stock of a company, they do research to determine whether a stock is a good investment. One way to determine the profitability of a potential investment is to evaluate the company's earnings per share (EPS). To use EPS as an effective investment tool, it's important to know exactly what the term means, how to calculate earnings per share and the potential limitations of the calculation. This guide works to help investors learn everything they need to know about EPS.
Earnings per share explained
Earnings per share is the amount of net income you make per share of a stock within a given time period. In other words, it defines how well a stock is performing in the current market. While different companies use the same calculations to determine EPS, there are many factors that impact the overall interpretation of the ratio. For example, a large company's share profits can't be effectively measured against that of a small company because the bigger company must split earnings across significantly more shares. That would be like trying to compare a national chain grocery store to the up-and-coming, independently owned small corner store in your town. Similarly, newer companies typically can't be expected to have an EPS similar to that of mature companies because they're often spending more to invest in company growth. So just because a company isn't earning money, doesn’t mean that it’s a bad investment.
A high EPS generally means that the company performed well during the specified earning period (typically a quarter or a year), and investors are more likely to pay a higher price for its shares. However, without considering all the aspects surrounding the company's earnings, it's easy to arrive at an inaccurate conclusion. While a low EPS could be a red flag, it's not a definite indicator of poor profitability in the future. For the most accurate results, investors should consider EPS as a temporary indicator of a company's overall performance and use the metric alongside other financial indicators. These factors include the return on equity ratio or the price-to-earnings ratio to determine whether long-term growth is likely.
Is earnings per share the same as stock price?
While EPS is not the same as the price of a stock, it can be expected to have an impact on the stock price. The relationship between the price of a stock and its earnings is called the price-to-earnings (P/E) ratio. The P/E ratio is calculated by dividing the current stock price by the company's EPS. This total reflects how much an investor must pay to get $1 of earnings for a company. While high earnings don't necessarily lead to high stock prices, high earnings over a long period of time are likely to drive up the value of a company's stock.
How to calculate earnings per share
To calculate earnings per share, you'll need to determine the company's net income over a specific time period (typically quarterly or annually) and the outstanding shares after preferred dividends are subtracted. Preferred shareholders have priority over a company's income, so they receive earnings before others such as common shareholders.
Therefore, preferred dividends are paid before the calculation of earnings for common stocks can be made. While preferred shares are less volatile than common shares, they are not purchased as frequently since common shares have higher long-term growth potential. For this reason, some companies have no preferred dividends to subtract before calculating EPS.
The formula for computing a company's EPS is simply the division of the company's net income, less preferred dividends, over a specific time period by the number of the company's shares outstanding.
For instance, if a company's net income is $18.3 billion, with $1.60 billion owed in preferred dividends, and if the company has 10.2 billion common shares, the formula computes EPS as follows: ($18.3 - $1.60)/10.2 = $1.63.
If the company has no preferred dividends, simply skip the subtraction and divide the net income by the number of common shares. Use of the formula provides this result: $18.3/10.2 = $1.79.
Basic vs. diluted earnings per share
The most common type of EPS calculation (which includes the one used above) is the calculation for basic EPS. Yet, basic earnings per share can fail to offer the widest range of information possible for potential investors.
Diluted earnings per share considers the EPS of common shares when all convertible securities are converted. While diluted securities aren't common stocks, they can be converted to common stocks. For example, it's common for companies to use financial offerings such as convertible debt and employee stock options to raise capital and motivate employees. If all of these options were simultaneously converted, the EPS for common stocks would decrease. While it's unlikely that all shareholders would convert options at the same time, there is a reasonable chance that these options would be converted to common stocks at some point. Therefore, diluted EPS offers investors the most conservative metric (worst-case scenario) of a company's EPS.
Public companies are required to report EPS on their income statement which can be found on the investor relations pages of a company’s webpage. Both basic and diluted EPS are listed, and the diluted EPS often receives more focus. However, the exact figure of diluted EPS is less important than the difference between basic EPS and diluted EPS. A large difference between the two indicates a high potential dilution for the company's shares, which impacts the long-term growth potential of common shares. It's important to note that a difference of a few cents between a company's basic and diluted EPS can represent a value of millions of dollars not available to investors.
Basic EPS is a simple measure of a company's profitability, and diluted EPS is a complex measure. By using these figures together, investors can obtain an accurate picture of how a company is faring financially.
How is earnings per share used?
Investors use EPS as one of many financial metrics to consider when determining whether to purchase stocks. A company's EPS is one of the most accessible metrics to determine whether a company is profitable. A company with strong EPS growth is often considered a company worthy of investment. Conversely, a company's declining EPS is considered a red flag, and potential investors should investigate the company further to determine the reason for the downturn.
Investors can find information about extraordinary events that may have impacted EPS by accessing their income statement and balance sheet. For public companies, this information is typically available on their website. Similarly, stock analysts like Morningstar often provide in-depth looks at the external factors impacting stock price, operational efficiency and EPS.
While EPS is a reliable metric for investors to use when choosing stocks, investors should use it alongside other metrics for best results. An investor may begin by examining the company's most recent earnings reports before looking at reports from the last several quarters to get an overall picture of the direction in which the company is trending. Investors will use these comparisons along with estimates from stock analysts of the expected EPS and the company's price-to-earnings ratio (which compares the company's stock price to EPS).
Limitations of EPS
Although EPS is considered one of the most dependable metrics of a company's profitability, it does have limitations when it comes to presenting a complete picture for potential investors. The most notable drawback is that EPS is calculated using a company's net income. While net income is often the most valuable indicator of income for an individual, a business's net income can fluctuate considerably due to depreciation, investments, temporarily increased expenditures, taxes or other volatile capital expenditures. This means that a company's net income may not always paint the most accurate picture of the company's success or loss.
For example, in Q3 2022, Ford Motor Company’s net profits and EPS declined. One reason was the rising cost of materials, but Ford also added the costs of investing in a self-driving business. Since this was an addition to their balance sheet, the overall profits reflected a loss, even though the investment in new technology could be a profit booster in the future.
Additionally, in an effort to attract investors, companies can manipulate their EPS numbers by buying back stock to reduce the number of shares outstanding. With fewer shares and the same amount of earnings, a company will temporarily have a higher EPS to entice investors.
What is a good EPS?
There is no hard and fast number to define a good EPS across companies. Since so many factors go into a company's net income and stock price, variables always exist from one company to the next. To determine whether a company's EPS is "good," it's essential to consider the company's earnings per share in context. A good EPS is determined by its year-over-year change. In a best-case scenario, a company's EPS value will accelerate upward yearly, and the rate of increase will increase as well.
A good place to begin is to examine analysts' estimates. Stock analysts compute estimates for both the current and next fiscal year. These estimates are widely available on financial websites. If a company's EPS isn't particularly impressive on its own but is higher than analysts estimated, it's a good indicator of growth. Conversely, if the EPS seems reasonable but failed to meet expectations, it warrants more investigation to determine the reasons for the slowed growth.
Comparing the company's EPS to that of competitors is another good way to obtain a clear understanding of a company's financial growth. For example, if you're considering investing in a specific bank, comparing its EPS to the EPS of other financial institutions of similar size can add clarity.
Can earnings per share be negative?
Due to a variety of factors, a company's earnings per share can be negative. While a negative EPS means the company is losing money, it doesn't necessarily mean the company isn't experiencing growth. To grow, businesses invest in property, tools, employees, and many other necessities to efficiently run the company. As a result, newer businesses can experience a few years of negative earnings before becoming profitable. Twitter is a good example: The tech company operated at a loss for eight years before turning a profit. However, if a mature company that has experienced positive earnings in the past were to report negative earnings, that change could indicate that it is losing market share and stock values could plummet.
Other factors that affect EPS
While earnings are an indicator of company growth, there are many factors that can impact the amount that a growing company reports in earnings. These factors can also mean radical changes or an EPS that fails to reflect a company's potential profitability. By taking such factors into consideration, investors can obtain a better indication of how a company's EPS accurately reflects the likelihood of long-term growth. Some of these factors are:
- Extraordinary items. A drastic gain or loss that isn't likely to be repeated in the future is referred to as an "extraordinary item." For example, the sale of company-owned property could inflate EPS while a natural disaster that damages a building would deflate EPS. By subtracting the cost of the extraordinary item along with preferred dividends in the EPS calculation, you can gain a more accurate understanding of the company's true EPS.
- Continuing operations. For businesses to stay current, they must remain flexible to meet customer demand and other economic factors. Such flexibility results in changes in spending and earnings. For example, when a chain retailer closes multiple locations, the EPS of that period won't accurately reflect the future growth of the company with fewer stores. By calculating the EPS of the company using only the earnings of the remaining stores, an investor can accurately determine how the closings will affect investment potential.
- Required capital. It's possible for two similar companies to have the same EPS without having the same earning power. A company that accomplishes high earnings with fewer net assets is generally considered a better investment because the company operates more efficiently.
Earnings per share key takeaways
EPS is a solid financial metric that investors use to determine the profitability of investment in a company. High earnings per share typically mean that a company is more likely to have extra profit to distribute to its shareholders as dividends. Since EPS is so widely used by investors who choose stocks, a high EPS can attract investors and further drive up share prices. Low or decreasing earnings per share means that a company is less likely to distribute some of its profits to shareholders as dividends. As a result, such a company can be a risky investment. Public companies report their EPS quarterly and annually. These metrics, used along with other financial indicators, can be a helpful guide to investors who are considering whether to purchase shares.