Why Is Earnings per Share Important?

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Knowing the earnings per share (EPS) of a company can go a long way when deciding whether to invest in a particular company. EPS is a metric that quickly identifies stocks with the strongest potential profit growth.

It is important to determine a company’s EPS. But what is EPS, and how does it work?

EPS as a Metric

The EPS is the portion of a company’s net income shareholders earn per share if the company paid out all its shares. It indicates a company’s financial help.

The EPS tells you how much a company makes for each share. It is primarily used for estimating corporate value. An increasing EPS tells you a company is becoming more valuable. A decreasing EPS tells you the opposite.

Importance of EPS

The EPS is one a few key factors to use when determining a company’s financial health. For example, when determining a stock purchase, evaluating its EPS is one indicator of the company’s current and future profitability.

A company with a steady increase in its EPS is a more reliable investment than a company with declining EPS.

Knowing the EPS is also valuable when evaluating it compared to other companies in the same industry.

Calculating EPS

There are two ways to calculate a company’s EPS. One is the basic EPS, and the other is the diluted EPS. But regardless of which you choose to use, you’ll need company information.

You'll need to know the net income and common shares outstanding. You can find this information in a company’s prospectus, which can be found on a company website or mutual fund. You can also ask your financial advisor for one.

Basic EPS Formula

This is a simple formula to determine the EPS. Use the company’s net income or earnings. Make sure you use annual net income. Don’t use quarterly. You’ll also need preferred dividends.

The common shares outstanding are also needed. Common shares outstanding are the company’s number of shares on the stock exchange.

The basic EPS formula is:

(Net income - preferred dividends) ÷ weighted average of common shares outstanding

So, the basic EPS refers to the total amount of a company’s net income it generates for each common share.

Preferred dividends are deducted from the net profit because dividends are payments. Think of them as interest payments to lenders—except the lenders are preferred shareholders and the payments are preferred dividends.

Diluted EPS Formula

The diluted EPS formula is very similar to the basic. It just takes it a step further and is a little cleaner. It also takes net income and preferred dividends. But in addition to shares outstanding, the diluted formula takes into account the conversion of any in-the-money options, warrants and other dilutive securities.

The diluted EPS formula is:

(Net income - preferred dividends) ÷ weighted average number of shares outstanding + the conversion of any in-the-money options, warrants, and other dilutive securities

Once more, preferred dividends are subtracted from net income.

Examples of dilutive securities are options, warrants, convertible debt securities and preferred stock with conversion feature.

Interpreting EPS Calculations

Earnings per share is basically a comparison number. An example of basic EPS is:

Acme Company had a net income of $14 billion. It pays out $2 billion in shareholder dividends. Over a year, they have had five billion shares outstanding.

EPS = (14 billion — 2 billion) ÷ 5 billion

EPS = 2.4

Run the numbers using different years for the company and note if there is a growth or decline in ESP. If you see the number rising, that’s a good sign. But if the number is trending downward, you might want to take note. A bigger ESP means a company is usually more profitable.

Comparing Companies Using EPS

Determining EPS can aid when deciding to invest in an industry. Comparing the EPS of companies in the same industry can give you a handle on each one’s profitability. It will let you know which one is growing or shrinking. Knowing the EPS levels the playing field and gives you a fair comparison.

EPS Limitations

Earnings per share do have some limitations. That is because the EPS doesn’t factor in cash flow, which gauges a company’s debt-repayment ability. Therefore, it might not be effective when determining a company’s solvency. And the EPS doesn’t take into account the debt a company holds.

Finally, a company can manipulate EPS. It can do this through a stock buyback and can show profitability. But this is a short-term effect and may hamper a company’s reputation.

EPS One Key to Buying Stock

To determine your chances of choosing a winning stock, examine the fundamentals. One key fundamental is EPS.

And although it does have some limitations, knowing the EPS will allow you to estimate the company’s potential growth. It will also allow you to compare one company to another.

Check with your financial advisor if you are interested in purchasing stock based on EPS.

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