Earnings Per Share, or EPS, is a measure investors commonly use for making informed investment decisions. In simple words, EPS calculates how much money a company is making for every share of stock it issues.
Although it is not a perfect metric, it is widely used as a way to measure the value of the company and the stock.
What is EPS?
EPS basically measures a company’s profitability. A company’s EPS is obtained by dividing its net profit by the number of common shares it has outstanding. In short, the higher the EPS of a company, the more profit the company makes per share.
The more money a company makes per share, the more attractive its shares will be to the investors. EPS is best employed in determining the changes in the profitability of a company over time or to compare the profitability of two or more companies within the same industry. EPS should always be assessed relative to the company’s stock price and used in combination with other financial metrics.
What Does EPS Indicate?
EPS is a crucial component in calculating the price-to-earnings ratio, that is, the P/E. Here, the E in P/E refers to EPS. By dividing the company’s share price by its earnings per share, an investor can determine the value of a stock in terms of how much the market is willing to pay for each dollar of earnings.
When used alongside other indicators, it provides investors with insights into how to choose stocks. Comparing EPS in absolute terms will not provide much meaning to the investors because ordinary shareholders do not have direct access to the earnings. But comparing EPS with the stock’s share price can determine the value of earnings.
How to Calculate EPS?
To calculate a company’s EPS, you can divide its net profit by the number of common shares it has outstanding. Companies typically list EPS and diluted EPS on their income statement. While these two measures are similar, they also include some important differences that investors need to be aware of.
Basic EPS = (Net income – preferred dividends) ÷ Weighted Average Number of Common Shares Outstanding
Diluted EPS= (net profit – preferred dividends) / ( Weighted Average Number of Common Shares Outstanding + diluted shares)
What are the Factors Affecting EPS?
EPS largely depends on the number of shares a company has issued. But factors, like changes in revenue, can also affect a company’s EPS. Let’s look into a few factors that contribute to altering the EPS of a company.
Stock Buyback: Companies can decrease the number of common shares outstanding through stock buybacks, which will reduce the total number of outstanding shares available, causing the company’s EPS to go up.
New Issuance: Companies can also increase the number of common shares outstanding by issuing new shares. Thus, the company’s EPS will go down.
Stock Split: Companies will also be able to increase the number of shares available through stock splitting. This will increase the total number of shares available, causing a company’s EPS to go down.
Company Revenue/ Profits: An increase in a company’s revenue or profits will increase its EPS, regardless of whether those increases are a result of increased sales or a reduction in costs. A reduction in a company’s revenue and associated profits will typically cause its EPS to go down.
Pros and Cons of EPS
Learning how to calculate the EPS and knowing what it means is indeed important. But it is also important to understand that these calculations aren’t the ultimate answer. EPS comes with its own pros and cons; let’s examine them to maximize its usage.
Pros of EPS
- EPS and share price are related to each other, meaning the EPS data will have a strong link to the share price. For instance, a high EPS leads to a high share price.
- It is easy to calculate if you have the formula and the context.
- EPS is the statistical measure of performance.
- By measuring EPS, you get to understand the value of a share with EPS, which means you get to know what a stake in the company is worth and what you could expect to receive.
Cons of EPS
- Negative EPS data can be unreliable.
- EPS can be manipulated; certain accounting policies and strategies can affect EPS.
- Using EPS could cause you to ignore the company’s share price.
Conclusion
Earnings Per Share (EPS) is indeed a profitability measure used in relating a stock’s price to a company’s actual earnings. In short, EPS is better, but one has to consider the number of shares outstanding, the potential for share dilution, and earnings trends over time.
FAQs
Is it good if EPS is high?
Companies with high EPS will be more likely to have extra profits to pay out as dividends to shareholders.
What are undervalued stocks?
Undervalued stocks are those with prices lower than their ‘fair’ value.
How long should you hold a growth stock?
While it varies, holding a stock for 3-5 years can aid you in tackling market volatility and benefit from long-term growth.
What are common investing mistakes?
Panic-selling, hiding out in cash, and forgetting to rebalance your portfolio are the common investment mistakes during the volatility period.
How to avoid a stock market crash?
Instead of investing all your savings in a single asset class, diversifying assets can help you from stock market crash.
