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What is EPS? Concept explained with formula and calculation

3 Mins 23 Sep 2022 0 COMMENT

Introduction

The profitability of a company is an important factor when investing in shares. Any investor buying stocks of a company wants to make profit. Without profit, investment doesn’t make sense, does it? A useful measure to understand the profitability of a company is to calculate its earnings per share.

What is Earnings Per Share?

Earnings per share or EPS is a common metric that is used to gauge profitability of a company. EPS can be defined as the value of earnings per outstanding shares of common stock of a company. In other words, EPS indicates a company’s profitability by divulging how much money a company can make for each of its shares.

EPS is determined by dividing a company’s net profit by the number of its outstanding shares of common stock. The higher the EPS of a company, the more profitable it is considered. Companies declare their EPS every quarter and in their annual results.

Formula for Earnings Per Share

EPS = Net Income After Tax/ Total Number of Outstanding Shares

However, this is a very simplistic method to calculate EPS. The net income also needs to be adjusted for preferred dividends paid. The formula for EPS will then be:

EPS = Net Income After Tax – Preferred Dividends / Total Number of Outstanding Shares

A company’s balance sheet and income statement are used to calculate a company’s EPS. Let’s understand this better with an example. Suppose ABC Ltd. has a net income of Rs. 12,00,000 at the end of the financial year 2022. It has paid preferred dividends of Rs. 2,00,000. It has outstanding shares of 5,00,000 at the end of the same period. Using the above formula, we can calculate EPS for ABC Ltd.:

EPS = (Rs. 12,00,000 – Rs. 2,00,000) / 5,00,000 = Rs. 2

For a more accurate representation of EPS, some investors use the weighted average number of outstanding shares instead of the end-of-the-year outstanding shares. Weighted average outstanding shares takes into account any changes in the share capital during the reporting period. For instance, if there was a new issue of shares in the financial year, or a stock split took place, these would be included in the calculation. This provides a realistic picture of the outstanding shares and helps calculate EPS more accurately.

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Diluted EPS

Another way to understand the profitability of a company is to calculate its diluted EPS.

Diluted EPS takes into consideration any dilutive securities. This means that any securities that are not currently outstanding shares, but could become in the future, are also considered. Examples include convertible preferred stock, convertible bonds, and stock options.

Diluted EPS = (Net Income – Preferred Dividends) / (Weighted Average Number of Outstanding Shares+ Preferred Stocks + Convertible Bonds + Stock Options + Other Dilutive Securities)

Dilutive EPS is often categorised as a conservative metric because the probability of conversion of all dilutive securities is minimal.

However, it helps to have this number on hand, just in case the scenario comes true.

How is EPS used?

Earnings per share is a vital measure of profitability for a company’s stocks. EPS is also a major component of important profitability ratios such as the price-to-earnings (P/E) ratio. By dividing a company’s share price by its EPS, an investor can understand how much the market is ready to pay for each rupee of earnings. In isolation, EPS will not give you much sense about the company's performance, but it can be used along with other parameters like stock price to assess a stock's valuation. EPS is also used to compare the profitability of similar stocks.

Importance of EPS

As already mentioned above, EPS is important to gauge the profitability of a stock you are investing in.

• EPS helps you understand the profitability of a stock. The higher the EPS of a stock, the more profitable it is.
• You can also compare the EPS of different companies in the same industry to understand which would be a better investment option.
• EPS is an important metric to gauge a company’s present and anticipated value. You can use EPS in financial ratios, such as the P/E ratio, to understand what a company’s value in the market.
• You can also look at the company’s historical EPS values in our online trading platform to understand whether the company’s profitability have increased in value over time. An increasing trend is a good indicator, signifying that the company is continuously increasing their profit. A declining EPS may not be a good sign. You will have to dig deeper to determine why its EPS is falling.

Takeaway

EPS is a good way to understand the profitability of a stock. However, EPS is not sufficient to tell you whether you can invest in a company. It has its own pitfalls. For instance, a company may report a one-time big sale that inflates its EPS. This is not a realistic representation. Instead, you should do a thorough analysis of the company and understand its financial health before investing in it.