What is EPS?
Earnings per share or EPS is the value of earnings per share of the company’s common stock. Companies often use this metric as an indication of their value and profitability. EPS reflects the amount of money made by a business.
To derive EPS, divide the outstanding shares of stocks of the company by its net profit. The higher the EPS, the more attractive it looks to investors . EPS is not only an indicator of a company’s current financial standing but also its performance over the past years. Read on to know more about what is eps in the share market, its calculation and its different types.
How to calculate EPS?
Earnings per share of a company can be calculated by dividing the company’s net income by the total number of outstanding shares. This EPS calculation can be done in two different ways:
1. EPS = Net Income after Tax / Total Outstanding Shares
2. Weighted EPS= (Net Income after Tax- Total Dividends) / Total Outstanding Shares
Let's look at how the EPS formula is used. A company XYZ has a net income of Rs. 10 lakhs and must pay Rs. 4 lakhs as dividends. It has an Rs. 3 lakhs weighted average of the shares. To know what is EPS for XYZ the calculation will be: = Rs. (10 lakh – 4 lakh)/3 lakh = Rs. 2 per share
EPS can also be diluted and non-diluted. If you want a diluted version of the ratio, it would also include convertible shares as well as warrants under outstanding shares. This gives an expanded version of the basic earnings-per-share ratio calculation.
- Non-diluted EPS= Net Income/Current Shares Outstanding
- Diluted EPS = Net Income/Current Shares Outstanding + Exercisable Rights on New Shares
Why earnings per share is important?
EPS is an important financial ratio when it comes to measuring the company’s profitability and financial standing. Investors in the share market consider this financial metric while making investments. Some reasons why EPS is important are:
- It helps in a comparison of the performance of promising companies. This helps the investors pick out profitable investment options and see which companies maximise profit from shares.
- A company can use EPS as a metric to compare its financial position over the years. A steady EPS rise reflects the stability of a company, making it a sound investment option. On the other hand, investors shy away from companies with irregular EPS.
- A higher EPS is a sign of profitability, indicating that the company’s dividend payout may also increase.
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Types of Earnings Per Share
EPS has several variations, each of which is related to a different aspect of this financial ratio. A company’s stock can be undervalued or overvalued based on the use of EPS. Generally, EPS can be classified into 3 prime categories:
- Trailing EPS– This EPS calculation is based entirely on the previous year’s numbers of a company.
- Current EPS- It is based primarily on the current projections and figures available.
- Forward EPS– Based on projected and estimated figures for the future.
There are 5 different types of EPS. Let’s look at them in detail.
1. Reported EPS or GAAP EPS
This type of EPS is derived by applying the Generally Accepted Accounting Principles. It is also disclosed in the SEC filings. However, GAAP may often reflect a distorted version of a company’s earnings.
A company’s EPS will increase if it generates income as operating income through a one-time payment in accordance with GAAP. Treating regular expenses as unusual expenses will artificially boost earnings per share.
2. Ongoing EPS or Pro Forma EPS
The base of this EPS is ordinary net income, and it excludes income that is generally considered a one-time, unusual income. Although this type of EPS reflects anticipated income from core business ventures, it is not an ideal indicator of the company’s real earnings.
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3. Retained EPS
A company retains EPS when it keeps its profits instead of paying out dividends to shareholders. The company uses these earnings to pay off any debts it incurs during expansion. The business may also retain this EPS for future requirements.
Retained EPS = (Net earnings + current retained earnings) – divided paid/total number of outstanding shares.
4. Cash EPS
Cash EPS is an indicator of the company’s financial standing. It reflects the exact amount of cash a company has earned. Cash earnings per share can be calculated as follows:
Cash EPS = Operating Cash Flow/ Outstanding Shares Diluted
5. Book Value EPS
Book Value EPS is the type of EPS which gives the average amount of company equity in each share. To estimate a company’s stake worth in the event of liquidation, one can use Book EPS. Since this EPS focuses primarily on the balance sheet, it is only a static representation of the company’s performance.
Disadvantages of earnings per share
Although EPS is an important financial metric, it does have some limitations for both business owners and investors:
- A business can easily manipulate EPS to project a profitable venture. In the long run, that business’s image can be tarnished by doing this, even if it only lasts for a short term. The business also loses the trust of investors.
- EPS calculation does not take into account the cash flow of a company. One cannot consider a high EPS as a true indicator of a company’s financial health. The cash flow of a company reflects its debt-repayment ability. Since EPS calculation does not factor in cash flows, a high EPS may still not indicate the company’s solvency.
- EPS calculations also do not factor in inflation. Hence, this financial metric may not show the company’s actual growth. For instance, the overall prices of goods and services may go up with inflation.
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Not considering inflation, the business’s EPS may give a misleading picture if it does not procure and sell more goods than the previous year.
Limitations of Earnings Per Share
While EPS is a widely used financial metric, it has some limitations that you should keep in mind. The main disadvantage of EPS is its potential for manipulation. Companies can sometimes inflate EPS by using accounting tactics like capitalising expenses or adjusting depreciation schedules.
For example, by recording certain operating costs as one-time expenses, businesses can artificially boost their EPS temporarily. This can mislead investors who rely on EPS to understand the profitability of investing in a company.
You should also keep in mind that EPS alone doesn’t provide a full picture of a company’s financial health, as it excludes aspects like cash flow and debt. A high EPS might look attractive, but it doesn’t necessarily mean that the company has the cash reserves or flexibility to repay debts.
Cash flow is very important in assessing a company’s liquidity and debt-management ability and EPS cannot reveal that.
EPS doesn’t adjust for inflation as well. Over time, as prices rise, a company’s EPS may seem stable or even grow, but this might not accurately reflect true profitability.
If you are assessing a company’s long-term growth, it is essential to adjust for inflation. Moreover, EPS doesn’t consider the company’s share price. This means that it cannot tell you about the overvaluation or undervaluation of a stock.
So, EPS is a highly valuable indicator but relying on it solely without considering other financial metrics could lead to an incomplete understanding of a company’s stability and growth potential.
Concluding thoughts
Investors use EPS as an important financial metric for gauging a company’s worth as an investment option, but they should also consider several other essential factors while evaluating a company as an investment option.
Earnings per share of a company should be considered along with other various financial parameters and not in isolation to get a clear picture of a company’s profitability and performance.
To get a clear picture of a company’s profitability and performance, investors should consider earnings per share along with other various financial parameters and not isolate it.
