EPS or Earnings Per Share is a financial metric used in the stock market by investors to check the profitability of each share in a company. It helps to know the amount of money possible to get from the particular share. It plays an important role in decision-making.
Types of EPS and Their Calculation in the Stock Market
EPS is mainly divided into two types: Basic and Diluted
Basic EPS
Basic EPS is the financial metric used to measure the profitability of a share currently outstanding during a specific period. The value of basic EPS is usually higher than the diluted shares because it is determined using fewer shares.
It is calculated by dividing the difference between the company’s net income and preferred dividends by Weighted Average Common Shares Outstanding.
Basic Value= (Company’s Net income – Preferred Dividends) / (Weighted Average Common Shares Outstanding)
Where Weighted Average Common Shares Outstanding is the number of common shares in circulation. Preferred dividends are the payments paid to the shareholders.
Diluted EPS
Diluted EPS also measures the potential of the company per share. Its growth potential can be determined. Unlike basic EPS, its measurement involves the potential future shares. This is why the value of dilute EPS is lower.
It is calculated using the formula,
Diluted EPS = (Company’s net income – Preferred Dividends) / (Weighted Average Common Shares Outstanding + Dilutive Securities)
What are the Uses of EPS in the Stock Market?
To Check Profitability
The profit gained through a specific common share in the company is measured using EPS. This shows the earnings acquired by the shareholders. Another way is to do the comparison. By doing so between similar companies, strategies can be added or removed to improve the performance.
To Measure the Stock Value
One of the main purposes of the EPS is the determination of stock value. This is done using the P/E ratio. The higher the ratio, the higher the growth and vice versa. Here, the potential analysis is done by comparing the historical P/E ratios of the company per share and between similar companies.
To make Proper Decisions
Buying, selling, or holding the stock are the main core processes of stock market activities. A small misunderstanding can change the decisions, which definitely affect the level of profit earnings. So, this can be time-consuming as it includes comparison and proper implementation of new strategies.
To Track the Accountability
Getting the best outcomes results only through proper management. This involves the use of efficient ways. A highly responsible ownership can give better accountability. By tracking accountability, the overall gains can be improved.
What are the Drawbacks of Using EPS in the Stock Market?
Chance to Get Manipulated
In the EPS formula, checking the number of outstanding shares or the Share Buybacks helps prevent being manipulated or misunderstood. In some cases, there won’t be much profit improvement, but its value increases. This occurs commonly when the mentioned outstanding shares in the formula decrease due to Share Buybacks.
Divergence between Net Income and Actual Cash Flow
Through EPS, not actual financial capacity is shown. Therefore, its accessibility in buy-sell processes is not shown. Instead of showing the amount of cash received or paid, the net income includes only the revenue they made and the expenses.
Over-comparison
Even though comparison is beneficial in business improvement, over-dependency on this method in the major decision-making process may give unreliable results. Before getting into this stage, some factors like regional differences, the type of stocks or businesses, and volatility differences need to be considered.
EPS as an Indication of the Company’s Efficiency
Generally, there are some factors based on which the growth rate is defined. But definitely, there is no specific value to determine whether it is successful or not.
Use of Several Benchmarks
This includes evaluating the company’s past performance. Knowing the position of one’s own company relative to other companies, and the use of the P/E ratio, are some of the effective methods.
Dividend Potential
If a company has high EPS, then it is capable of offering regular payments. And the stable EPS denotes the ability of the company to expand its business without relying heavily on debt.
The Growth Pattern
Both consistency and sustainability can be seen by observing the pattern or the trajectory. The steadily increasing EPS shows a great improvement in performance. Whereas any fluctuation, like a rise and fall in the pattern, shows the instability and the volatile issues.
The Bottom Line
With a lot of merits, the EPS is a non-negligible standard of measurement in the stock market. Along with its multi-purpose in areas like profitability, decision-making, stock valuing, and accountability tracking, some drawbacks are also present. Its limitations compel us to rely on different metrics other than EPS. Nevertheless, EPS is one of the important tools in navigating one’s company through the right track.
