Stock trading requires a keen and detailed analysis of various quantitative measures. The two broad categorisations of tools that help in this are- fundamental analysis and technical analysis.
Technical analysis aims to evaluate the possible performance of a specific share in the future depending on past price records and the volume traded. Fundamental analysis helps in measuring the fiscal health of a company through parameters that use information collected from the financial statements of a corporation.
Earning per share (EPS) is a tool used in fundamental analysis.
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What is EPS?
A company raises funds by issuing equity shares. The company gives out a part of its revenue after deducting expenses to its stockholders. Earning per share (EPS) indicates the amount of income that a shareholder receives on a share of the company.
EPS = (Net Income – Preferred Dividends) / Shares Outstanding at the end of FY
EPS = (Net Income – Preferred Dividends) / Weighted Average Shares Outstanding
Preference shares always get precedence over equity shares. After deducting dividends payable to preference shareholders, the remaining amount is distributed among the equity shareholders.
Weighted average shares outstanding are the average number of shares in a corporation computed after accounting for variations in share capital throughout an accounting period. The number of outstanding shares of a corporation fluctuates over the year owing to share buybacks, fresh issues, conversions, and so on.
The shares outstanding which form the denominator of the EPS formula, set the precedence for the classification of EPS based on capital structure into basic EPS and diluted EPS.
What does basic EPS mean?
Basic EPS informs shareholders what proportion of a corporation’s net revenue is allocated to a particular stock. It appears on the business’s income statement. The formula for basic EPS is the same as that of EPS.
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What is the impact of basic EPS?
The movement of stocks is greatly influenced by this metric. An appreciation in basic EPS could trigger a stock’s price to increase.
However, a rising basic EPS does not imply that the firm is earning more on a gross basis. Consider a situation where corporations buy back shares. This reduction in share capital structure will lead to the distribution of net income (excluding preferred dividends) over a smaller number of common shares, resulting in a rise in EPS. Basic EPS may rise even if the actual company income falls due to a decline in the number of common shares.
While the basic EPS is theoretically similar to the umbrella concept of EPS, diluted EPS can be seen as a subset that deals with a particular use case.
What is diluted EPS?
Diluted EPS is the data used in analysing a company’s financial statements to assess a corporation’s earnings quality after convertible securities have been executed. Below is the formula for diluted EPS. It will help us understand this metric better.
Diluted EPS = (Net Income – Preferred Dividends) / Average Shares Outstanding + Dilutive shares
Here, dilutive shares refer to convertible securities composed of all existing convertible preferred shares, convertible debt instruments, equity options (mostly employer-based options), and warrants.
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Basic vs diluted EPS
The basic EPS is theoretically synonymous with earnings per share. The classification of EPS is to accommodate the specific use case that diluted EPS offers. Although the distinctions have become quite apparent, listed below are a few other parameters that differentiate the two types of EPS.
Capital structure
If a corporation has a simple capital structure that does not have convertible securities, only the basic earnings per share is sufficient. However, in the case of a more complex capital structure that offers convertible securities, basic EPS is not enough. A company must disclose its diluted EPS along with basic EPS.
Effectiveness
For optimum financial analysis, diluted EPS is more efficient since it accounts for every possible equity diluters. This guarantees that the company’s EPS is consistent with future growth. As a result, this is essential when calculating the price-earning ratio.
Dilution and effect
Unlike the basic EPS, diluted EPS adjusts the distributable earnings with the effect of convertible securities. Diluted EPS remains less compared to the basic since the denominator for diluted EPS also accounts for all the exercised convertible.
Conclusion
Both basic EPS and diluted EPS are very useful tools that help determine the financial health of a company. Basic EPS and diluted EPS differ mostly due to the scale in which they operate. Investors need to use these metrics selectively so that they can optimise their understanding of the financial health of a business.
The EPS cannot be used only. It has to be complemented with other tools of technical and fundamental analysis to make investor judgments well-informed. EPS can often fail to accurately reflect upon the financial performance of a company due to the manipulation of stocks.
FAQs
- What is the difference between adjusted EPS and basic EPS?
Adjusted EPS is a kind of EPS computation in which an individual makes changes to the numerator. Usually, this involves adding or eliminating non-recurring elements of net income. If the business’s earnings increased due to a single property sale, the analyst may subtract the revenues from that transaction, lowering net income.
- What is the difference between basic EPS and cash EPS?
A basic EPS calculates a business’s profitability by dividing the net earnings by the weighted average of outstanding shares. Higher earnings per share (EPS) imply a more profitable corporation.
Cash EPS evaluates a company’s capacity to create cash by dividing operational cash flow by outstanding shares.
- What is the difference between normalised EPS and basic EPS?
The primary distinction between normalised earnings per share (EPS) and basic EPS is that normalised EPS modifies the financial statements to account for economic cycles and one-time costs. However, basic EPS quantifies the net income a firm provides per common share.
- Which EPS is better?
No earning per share is better than the other. Each EPS serves best under a particular circumstance. If a corporation’s capital structure is simple and does not include convertible instruments, basic EPS is adequate. However, in the event of a more sophisticated capital structure, a corporation must declare both diluted and basic EPS.
- Is a higher basic EPS better?
Increased basic EPS does not always suggest that the company is generating more on a gross basis. Consider a situation in which firms repurchase shares. This reduction in share capital structure will result in the distribution of net income over a reduced number of common shares, increasing EPS.
