The earnings per share (EPS) ratio is a financial ratio calculated by taking the net earnings and dividing it by the outstanding shares available to the common stakeholder over a given period. Therefore, it shows the ability of a company to generate net profits for the stakeholder.
The ratio is used to compare companies against similar companies in the industry. A higher EPS value indicates a company’s profitability when comparing two companies in a similar industry that have the same outstanding shares number. It is usually used together with the business’s share price to assess whether it is an expensive-high P/E ratio or a cheap-low P/E ratio.
Investors use EPS with profit margin calculations to determine the company’s profitability before purchasing shares. It denotes the company’s portion of the profit that each shareholder gets on a single stock share. The company is said to have a strong gross profit margin if the earnings per share are high. This indicates the business operators are executing on their overall pricing strategies while also demonstrating how effective the company in controlling its cost of goods sold.
Investors calculate EPS by dividing the variance between a company’s total income and dividends paid for each share outstanding by the weighted average number of outstanding shares.
Earnings Per Share Ratio = (Net Income – Dividends on Shares) / Weighted Average for Outstanding Shares
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Suppose a company pays out $5 million in dividends to shares outstanding while their net is $40 million and has $20 million shares outstanding for one quarter and $25 million shares outstanding for a different quarter. In that case, the earnings per share will be:
$40 million – $5 million = $35 million
The average for the two shares = 20 million shares / 25 million shares = 22.5 million shares
Therefore, EPS = $35 million / 22.5 million shares = $1.55 / shares
Another formula for EPS Is:
Earnings Per Share Ratio = (Net Income – Preferred Dividends) / Shares Outstanding during Period
Importance of EPS
The earnings per share ratio serve as a representative of the financial health of a company. EPS is the portion of the company’s net income paid to shares outstanding. This represents the percentage of profit that the corporation has earned and is represented on the balance sheet as a line item under stockholder equity.
The traders and analysts use the EPS ratio to measure the strength of a company. It is one of the critical tools in defining the value of a stock. EPS serves as the company’s bottom line on the income statement so investors can calculate a company’s worth.
A higher EPS denotes the ability of a company to pay its shareholders more dividends. Thus, a company will increase the dividends payout with an increase in earnings.
Investors can also use the EPS to compare between two or more companies to understand a company’s performance to its peers. The EPS can also study a company’s EPS growth over time and predict future trends. A company with a consistent increase in EPS is more reliable than a company with an inconsistent or decreasing EPS.
Earnings per share ratio are also important in determining the value of a stock. The measurement figures into the price-earnings portions value ratio. The P/E ratio enables investors to assess whether a stock price is appropriately valued according to its earnings.
Diluted Earnings per Share
The difference between the formula for basic earnings per share and the diluted earnings per share is the former only considers the company’s shares outstanding. In contrast, the latter takes into account all the convertibles securities. A company could be having convertible preferred stock or shares options that can be converted into common shares. If this happens, the earnings per share are reduced. Thus the diluted earnings per share will be lesser than the basic earnings per share.
From our example above, if the company issues 3 million convertible shares, the net earnings per share will be $35 million/ 25.5 million shares = $1.37
Limitations of EPS
Since the company has the privileges of buying back its shares, this can improve the EPS ratio by reducing the number of outstanding shares without necessarily increasing the net income. Thus companies can use this strategy to manipulate investors into believing that the company is going better. Additionally, the earnings per share ratio do not account for issues such as outstanding company debts.
The earnings per share also do not reflect the capital used to raise profits being studied. Suppose two companies have the same EPS ratio, where one uses less capital to gain earnings. In that case, it is probably because the company effectively manages its resources better than its counterpart. That may not be mirrored in the EPS.
The computation of both the diluted EPS and basic EPS needs to be adjusted every time there is an increase in the figure of potential or ordinary number of shares outstanding due to share-split, bonus issue, capitalization, or decreases from the reversal of a share split. If changes occur after balancing financial statements and before they are authorized for issue, the EPS for the changes are based on the new value of shares.
Types of Earnings per Share Ratio
It includes all four quarters of the current financial year. Some might have elapsed or are on the way coming. As such, the data used will partly be from projections and actual data.
It is based on the previous year’s after-tax profit numbers. It uses data from the past four quarters and benefits from actual data as opposed to projections. The Price-earnings ratio is mostly computed using the trailing EPS as it represents what happened but not will happen. Most investors prefer using the forward or current eps ratio, although the trailing ratio can give accurate figures.
It is based on future projections. It includes numbers projected for some period to come in the future, primarily the first four coming quarters. A company or analyst can make the Forward EPS estimates. Investors prefer the forward EPS ratio as investments are majorly on the company’s predicted future earnings potential.
Investors typically compare all these EPS ratios. For instance, if a comparison is made between the current EPS and forward EPS and the current EPS’ happen to be less than the Forward EPS, there will be a fall in the common stock price. On the other hand, if the current EPS is greater than the other EPS, the stock’s price will shoot.
Investors can use the EPS ratio to determine the company with room for increasing the current dividends. EPS should not be used alone but in conjunction with other metric ratios. Investors should also compare the EPS of different companies to make a more informed investment decision.
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