Evaluating investments can be confusing for beginner investors, especially because so many different financial indicators work together to indicate whether a company is a good investment.
Below is a discussion of earnings per share and how investors can use it to determine whether they want to invest their money into a specific company.
What Is EPS In Stocks?
Earnings per share (EPS) is a company’s net income divided by the number of common shares outstanding, which indicates how much the company makes per share of stock. Put another way, EPS is how much of the company’s net income is available to common shareholders.
Basic EPS is required to be reported, but some companies will also calculate their diluted EPS. Diluted EPS mathematically converts dilutive securities, such as bonds and preferred shares, to common stock and calculates the EPS based on those hypothetical numbers.
Types of Earnings Per Share
There are five types of earnings per share ratios, including:
- Reported or GAAP EPS: This is the EPS calculated using generally accepted accounting principles and used in a company’s SEC filings.
- Ongoing or Pro Forma EPS: This is calculated by excluding one-time financial events from the company’s net income to get an EPS that is more accurate to the company’s typical earnings.
- Carrying Value or Book Value EPS: This calculates the equity per share of common stock, which shows investors how much their shares would be worth if the company had to be liquidated.
- Retained EPS: This EPS is calculated by adding the retained earnings and subtracting the dividends paid from the net income before dividing by the number of common shares outstanding.
- Cash EPS: This is calculated by using operating cash flow instead of net income, which can be more accurate since it’s harder for companies to shift operating cash flow numbers.
Companies may use different types of EPS depending on what message they are trying to relay to investors and the media.
What Is a Good Earnings Per Share Ratio?
No set EPS value is considered “good” earnings per share. However, the higher the EPS, the more profitable a company is, and investors will benefit the most from considering the company’s profitability as a whole. In many cases, it is recommended that investors take into account other metrics combined with EPS, such as stock price.
EPS should also be compared to other companies in the same industry and of a similar size to determine what is a relatively good ratio for a specific company. To compare companies of different sizes, investors can calculate the percentage change in EPS over a certain period.
There may be some cases where a company has a negative EPS, but this doesn’t necessarily make it a bad investment. For example, a company may have a negative EPS if it makes large investments. That’s why taking the EPS into consideration with other factors is so important to evaluate a company.
How Is Earnings Per Share Used?
As mentioned above, earnings per share can be used with other financial indicators to understand a company’s profitability. For instance, investors can use EPS to calculate the price-to-earnings ratio.
The P/E ratio is calculated by dividing the stock price by the earnings per share, and it can help an investor see how much they will have to pay for the share’s earnings.
In addition to using EPS with other metrics, investors should compare current and past EPS ratios. Suppose the ratios are moving upward over time. In that case, the company is increasing its profitability. If it’s moving downward over time, it indicates that the company is not as profitable as it was in the past.
Another good way to use the EPS is to compare it to financial experts’ estimates. If a company’s EPS is coming in under estimates, investors should find out why and be aware that fluctuations in stock prices may occur.
The Disadvantages of EPS
While EPS can provide some value to the investor, it doesn’t allow an in-depth look at the company and its use of funds.
The EPS will not take into account how companies are spending their earnings or how their expenses have changed over time. For example, a company could have a negative EPS if they are spending a lot on growth opportunities or if they come up against unexpected expenses that are out of their control.
In addition, the EPS cannot tell an investor how well the company is projected to do in the future. The company may have an excellent EPS but poor sales estimates in the next quarter or vice versa. Therefore, it is important to use EPS in combination with other financial indicators.
How EPS Is Calculated
Simply put, earnings per share is a company’s net income divided by the number of common shares outstanding. However, there’s a little more to the formula to make the numbers more specific.
EPS = (Net income – preferred stock dividends) / Number of common shares outstanding
Businesses generally use the weighted average of the number of common shares outstanding, but some may also use the number of common shares outstanding at the end of the period.
For example, if a company reports $500,000 of net income, $35,000 in preferred stock dividends and 2,500,000 common shares outstanding, the formula would appear as:
EPS = ($500,000 – $35,000) / 2,500,000
Therefore, the EPS would be $0.186.
Earnings per share gives a very simplified look at a company’s profitability. However, investors should use it with other metrics, such as the P/E ratio. Investors must also compare the EPS over time and throughout the company’s industry to see how it compares to other companies.
EPS is a very small part of investment analysis, so individuals should ensure that they are looking at all of the other aspects of a company’s financial performance before investing.