What Does EPS Stand For in the Stock Market?
Understanding Basic EPS and Diluted EPS
If you hop onto a financial news website, read a financial magazine, or watch the financial news, you are likely to hear the phrase EPS when discussing how profitable a company is. What is EPS? What does EPS stand for and why should you care?
The Definition of EPS
Simply put, EPS is an acronym that stands for Earnings Per Share. In effect, there are two types of EPS figures that investors are likely to encounter when studying a company's income statement in the annual report or Form 10-K: Basic EPS and Diluted EPS. They each tell the investor different things.
- Basic EPS - A company's Basic EPS, or Basic Earnings Per Share, is the company's profits divided by the number of shares outstanding. This is usually calculated on both an annual and quarterly basis. If the company earned $500 million and had 250 million shares of stock issued and outstanding, Basic EPS would be $2.00, because $500 million profit divided by 250 million shares = $2.00.
- Diluted EPS - A company's Diluted EPS is the same thing except the shares outstanding figure is adjusted to include shares that might or will be issued in the future. If a company has a significant amount of potential dilution lurking in the books, the "real" EPS figure would be lower than the basic EPS figure in profitable years because the net income would need to be split by more shares. Personally, I'm far more interested in Diluted EPS.
The Reason Basic EPS and Diluted EPS Figures Are Important to New Investors
Why is EPS so important? Many conservative investors use Basic EPS and Diluted EPS to calculate how much they think a stock is worth. Specifically, EPS forms the basis of several important financial ratios including:
- The Price-to-Earnings Ratio or P/E Ratio - If a stock is trading at $30, and the Basic EPS for the year is $3.20, then it can be said that the p/e ratio is about 9.4. The p/e ratio of a stock tells you how many years it would take a company's basic EPS to pay you back your investment cost assuming no taxes were owed on distributions, there was no growth, and all earnings were paid out as cash dividends. The p/e ratio can be inverted to calculate the earnings yield.
- The PEG Ratio - The price-to-earnings growth ratio, or PEG ratio, is a modified form of the p/e ratio that takes basic EPS and then calculates the p/e ratio with an adjustment for the projected growth in earnings per share over the coming years. To learn more about this, read Using the PEG Ratio to Uncover Hidden Stock Gems.
- The Dividend-Adjusted PEG Ratio - Going one step further, the dividend-adjusted price-to-earnings growth ratio, or dividend-adjusted PEG ratio, is a modified form of the PEG ratio that takes the basic EPS figure and then takes into account the valuation not only for the expected growth in future earnings per share but also the dividend yield. To learn more about this, read The Dividend-Adjusted PEG Ratio Can Help You Find Undervalued Blue Chip Stocks.
Figuring out which multiple to EPS to pay for a company can be tricky. Some investors set hard and fast rules, which aren't necessarily intelligent as they don't factor in inflation, taxes, and risk, such as only paying 10x earnings for a stock. Other people pay 8.5x EPS + the expected rate of growth in EPS, a formula highlighted by legendary value investor Benjamin Graham.
Basic EPS and Diluted EPS are also important because dividends are ordinarily paid out of profits. This means that if a company has EPS of $2.00, it can't pay dividends of $3.00 indefinitely. It's just not possible. Dividend investors look at the percentage of EPS paid out as dividends to gauge how "safe" a company's dividend payment is. For more information on this topic, read What Is Dividend Investing?.