Earnings per share (EPS) is the ratio between a company's net earnings and the average number of outstanding shares for a specified period. EPS indicates a corporation's ability to produce profits for shareholders.
Learn about earnings per share and how you can use the ratio to evaluate a stock.
- The basic earnings per share (EPS) ratio represents the amount of profit a company makes on each outstanding share.
- Diluted EPS pulls additional convertible securities into the ratio.
- EPS is a crucial ratio used in many other formulas that analyze a company's finances.
- EPS is not useful for comparing companies because it does not include cash flow or adjust for different accounting methods.
Definition of Earnings Per Share
Earnings per share is the ratio used to indicate how much profit a company makes per share, using the average number of outstanding shares (the number of common stock currently held by stock owners).
Investors use EPS to help them determine an investment's value. If a corporation has high earnings per share, each share has a higher potential to create returns for an investor. It also indicates that a company is using investors' funding to generate profit.
Earnings per share is sometimes called "normalized earnings per share" when using reported profits from annual reports because sometimes companies "normalize" their profits by removing one-time expenses or smoothing out seasonal cycles.
The ratio uses a weighted-average number of shares because the number of outstanding shares varies at any given time. Doing this factors out the variability and gives you a general indication of a stock's profitability over longer periods.
Calculating Earnings Per Share
There are two types of EPS used to measure profitability for shareholders: basic EPS and diluted EPS.
A company's basic EPS is its profits divided by the number of shares outstanding. The information needed is taken from a business's income statement or annual report.
To calculate EPS (if the company didn't do it for you in its annual report), use the following formula. If it has preferred shares (which most don't), the dividends from those shares are not included because preferred stock dividends are paid before common stock dividends:
Weighted-average shares outstanding (WASO) is calculated by adding the number of dividends distributed each period, then dividing the total by the number of periods. Calculate the WASO, where Sharespx is the amount of shares paid in each period and Npt is the total number of periods:
Investors usually calculate EPS on both an annual and quarterly basis. For instance, if the company had annual earnings of $500 million and had 250 million shares of stock issued and outstanding (in one period), its basic EPS would be $2.00.
If the same company had $500 million in earnings over two quarters—250 million shares outstanding in one quarter, and 275 million outstanding the next—its EPS would be $500 million ÷ (($250 million + $275 million) ÷ 2), or $1.90.
A company's diluted EPS measures the effect of adding all convertible securities that can be converted to common stock. In general, common convertible securities held by corporations are bonds or preferred stocks.
Depending on a company's capital structure, diluted EPS is commonly calculated by adding dilutive shares to the EPS formula:
How To Use EPS
Basic and diluted EPS are used during financial analysis to determine whether an investment has value for an investor. Earnings per share is best used as a comparative ratio between different reporting periods to gauge one company's financial performance.
You can use diluted EPS to see what would happen if that company were to convert assets to common stock, which occasionally happens. Other financial ratios use EPS in their formulas, helping you evaluate a company further:
- The Price-to-Earnings Ratio or P/E Ratio: If a stock is trading at $30 and its basic EPS for the year is $3.20, then the firm's P/E ratio is approximately 9.4. This tells you that it would take more than nine years to earn back the $30 spent on the stock, all else remaining the same.
- Earnings Yield: The P/E ratio can be inverted to calculate the earnings yield, which is the percentage of a company's earnings per share.
- PEG Ratio: The price-to-earnings-growth ratio (PEG ratio) is a modified form of the P/E ratio that uses the basic EPS and adjusts for the projected growth in earnings per share over the coming years.
- Dividend-Adjusted PEG Ratio: The price/earnings to growth and dividend yield ratio (PEGY) is a modified form of the PEG ratio that takes basic EPS and accounts for the expected growth in future earnings per share along with the dividend yield.
Limitations of EPS
While the EPS is an important financial metric when it comes to analyzing a company's financial performance, on its own, it doesn't tell an investor much about a company because of the difference in company accounting and reporting procedures. While all public companies report finances in the same format, they do not all follow the same internal accounting methods.
EPS shouldn't be used to determine the value of the stock compared to other companies. It should be used in conjunction with other financial ratios when conducting an analysis of one business.
How a company handles its supply and flow of cash are of utmost importance to investors. Cash flow is not accounted for in EPS, so a company can skew information enough to make it appear to have an excellent ratio but not have enough cash to support future operations.