What is Earnings Per Share (EPS) and How to Calculate It?

What is Earnings Per Share (EPS) and How to Calculate It?

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Earnings Per Share, or EPS, is a widely used financial ratio that investors apply to gauge a company’s capability of generating earnings per share held during the relevant period. It is effectively a single number that demonstrates the profit left over for shareholders. A company possessing a higher EPS ratio indicates greater profitability and vice versa for a company with a lower EPS. 

The EPS metric is not only a standalone indicator but also a key component in calculating other financial ratios, such as the Price-to-Earnings ratio (P/E ratio). The P/E ratio, a popular valuation ratio among investors, measures the current share price of a company relative to the company’s EPS number over the previous four quarters. It provides a single value that reflects how much investors are willing to pay for each dollar of a company’s earnings. 

While understanding EPS can be useful when assessing a stock, it is vital to recognise that the ratio is rarely used in isolation and should be considered in the context of other financial information. For instance, the EPS value is deemed more useful when assessing it against a benchmark or other companies in the same industry. 

Calculating the EPS Ratio

Investors often calculate two ratios for EPS: Basic EPS and Diluted EPS. Public companies are required to report both ratios on their income statements, which display a company’s income and expenditures. 

Basic EPS

The Basic EPS formula involves dividing the difference between net income (found at the bottom of the income statement) and preferred dividends (listed on the cash flow statement under Financing Activities) by the weighted average number of shares outstanding (also available on the income statement – see the income statement for Microsoft Corp. [Ticker: MSFT] below). The shares outstanding represent shares of common stock. 

Preferred shareholders have a preferential right to receive dividends before any payout to common shareholders. So, to determine the portion of profits available to common shareholders, we need to subtract the preferred dividends from the net income. For the denominator, the weighted average number of shares outstanding considers any changes in the number of shares outstanding throughout the period being considered. A simple average wouldn't capture this accurately.

Diluted EPS

Another way of calculating the EPS ratio is using diluted shares outstanding. Dilutive securities are those that could be converted into common shares at some point in the future, including securities like convertible preferred shares, convertible debt and stock options. Financial analysts, and particularly investors, need to be aware of Diluted EPS values as if these shares are converted into stock, your piece of the pie (your stake in the company) will be smaller. 

As a point of note, the Basic EPS is usually higher than the Diluted EPS due to convertible securities being added to the common shares in the denominator. To calculate the Diluted EPS, the numerator is the same as we used in the Basic EPS, but the denominator will add the diluted shares to the weighted average number of shares outstanding. 

To extend our understanding, we can also calculate the Diluted EPS ratio for things like convertible preferred shares. You must understand that if the diluted preferred shares were converted into common shares, the preferred dividends part of the numerator would essentially be zero. To do this, you would divide net income by the weighted average shares outstanding, which would now include those convertible preferred stocks.

Some Limitations of the EPS Ratio

• The first and most obvious limitation of the EPS value is that it is open to manipulation and can also be affected by a change in the company’s accounting policy. As a basic example, a company could manipulate its EPS by buying back shares. If a company does buy back its shares, this will reduce the number of shares outstanding (which is the denominator in the EPS formula) and, therefore, increase the EPS value. 
• Reducing expenses is another way of manipulating the EPS. This could increase net income and, therefore, inflate the EPS value. However, this is unlikely to be sustainable, particularly if the company is downsizing research and development or marketing. 
• The EPS does not take into consideration the company’s debt levels. A company can still have a high EPS value even with high debt levels.