Calculating net profit margin is not enough in order to invest in a company. You have to analyse the company from all steps in order to know whether the stock is a good investment for you. One of such factors is earnings per share or EPS.
Earnings Per Share (EPS) is one of the most important metrics for an investor. Companies while reporting their income statement, mention the quarterly and yearly earnings per share (EPS) on the face of the income statement.
Both Basic and Diluted earnings per share are reported in the income statement to tell you how much profit the company generates per share outstanding.
By presenting basic and diluted earnings per share (EPS) in the Income statement, a shareholder can easily compute his or her share of the company’s earnings.
EPS is an input into various ratios such as price to earnings (P/E) ratios.
Earnings per share or EPS is calculated by dividing net earnings of the company by the average number of stocks outstanding. It basically tells you how much of a slice of a company’s net earnings you are entitled to as a shareholder.
Earnings Per Share is a very good comparison toll as comparing earnings of one company to another really doesn’t make any sense. EPS has much importance to people who invest in the stock market.
Earnings Per Share or EPS = Company’s Net profit / Number of Outstanding Shares
Company’s net profit or income as it’s used in the above formula is defined as the sum of all revenues less expenses, including operating, selling, administrative, other expenses, depreciation, interest, taxes, and dividends paid to preferred stockholders.
EPS measures the amount of net income or profit earned per share of stock outstanding. In other words, EPS represents a portion of a company’s profit that is allocated to one share of stock.
This means, EPS will indicate the amount of profit each investor will receive in proportion to their holdings if all the profits were distributed among them at the end of the year.
For instance, suppose that company X and Y earns 1, 00,000 rupees each but company X has 1, 000 shares outstanding, while company Y has 500. In this case owners of company Y will be benefited more in comparison to company X as earnings per share is more.
Capital structure and EPS
If you look at the capital structure of a company, in many cases you will find it is composed of both equity and debt. Within equity, you have preferential shares which have preference over common shareholders.
Common shareholders are holding ordinary shares which are subordinate to all other types of equity. These people are paid last in a liquidation of the company and rewarded the most when the company does well.
The company may have certain types of securities that are potentially convertible into common stock. These types of securities include convertible bonds, convertible preferred stocks, and employee stock options.
If the capital structure of a company has these securities which are convertible to common stocks, it is said to have a complex capital structure. Otherwise, it is said to have a simple capital structure.
From this capital structure, we have two different types of EPS. Any security that is potentially convertible into common stock could as a result of conversion can potentially decrease EPS. Such information is valuable to company’s investors and other market participants.
Therefore, as per law, companies are required to disclose diluted earnings per share (EPS) on the face of the income statement in addition to basic EPS.
Diluted EPS will show what the company’s earnings per share would be if all dilutive securities were converted into common stock.
How to calculate Earnings Per Share (EPS) of a company
Here is the formula to calculate basic and diluted earnings per share (EPS);
Basic earnings per share (EPS) = (Net income – preferred dividend) / Weighted average number of shares outstanding
Weighted average number of shares outstanding = the time weighting of common shares outstanding.
For example, suppose a company has 20,000 shares at the beginning of the year. During the year, on 1st October, the company repurchased 10,000 shares. In this case, the weighted average number of shares outstanding would be the sum of followings;
(20,000 shares * 1/2 year) + (10,000 shares * 1/2 year) = 15,000 shares
In this case, the company would use 15,000 shares to calculate basic earnings per share (EPS).
EPS or earnings per share measures the amount of return per share to the equity owners of a company. For this reason, it’s always a good idea to look for earnings per share or EPS of a company before investing. You can find all this information in a company’s financial statements as it’s a must for companies to disclose.
If the company has decided to pay a dividend then net earnings should be taken by subtracting preferred dividends. Preferred dividend is an amount of money that is paid out to preferred stockholders by the company during the year from the company’s profit. The reason for this subtraction is to measure the income available to common stockholders.
Many times you will find weighted average common shares used in the EPS calculation. This happens as companies often issue new stocks or buy back their own stock throughout the year. Weighted average of common shares can be calculated by adding the beginning and ending outstanding stocks and dividing it by two.
When calculating Earnings Per Share, it will be more accurate if the weighted average number of stocks outstanding is used in the denominator, because the number of stocks outstanding can change over time.
Earnings Per Share or EPS = (Net Income – Dividends on Preferred Stock) / weighted average Outstanding shares
Example to calculate Basic EPS
For the year ended 31st March 2022, company XYZ limited had net income of Rs 25,00,000. The company declared a dividend of Rs 2,00,000 on preferred stock.
Here are the company’s common stock share information;
- Shares outstanding as on 1st April 2021 = 10,00,000
- Shares issued during the year on 1st July 2021 = 2,00,000
- Shares repurchased on 1st January 2022 = 1,00,000
- Shares outstanding as on 31st March 2022 = 11,00,000
Let us calculate followings;
- Company’s weighted average number of shares outstanding;
- Company’s basic earnings per share (EPS)
Weighted average number of shares outstanding = [1,000,000 * (3 months/12 months)] + [1,200,000 * (6 months/12 months)] + [1,100,000 * (3 months/12 months)] = 11,25,000
Basic earnings per share (EPS) = (Net income – Preferred dividends) / Weighted average number of shares = (Rs 25,00,000 – Rs 2,00,000) / 11,25,000 = Rs 2.04
Example to calculate Diluted EPS
Diluted EPS will be calculated to know what the company’s earnings per share (EPS) would have been if the convertible securities had been converted at the beginning of the period.
This means, what would have been the effect if these convertible securities had been converted?
Basic EPS will be the same as diluted EPS if the company has a simple capital structure.
In case the company has dilutive securities, then diluted EPS will be lower than its basic EPS.
Here is the formula to calculate diluted EPS;
Diluted EPS = (Net income) / (Weighted average number of shares outstanding + New common shares that would have been issued at conversion)
Example 2: How to calculate Basic Earnings Per Share or EPS
Assume that company Z has a net income of 25,000 rupees. If the company has paid 1, 000 in dividends and has 10, 000 stocks for half of the year and 15, 000 stocks of the other half, EPS would be calculated as follows;
Earnings Per Share or EPS = (25,000 – 1,000)/ {(10,000+15,000) / 2} = 24,000 / 12,500 = 1.92
In the above calculation we have deducted 1,000 dividends from the net income of 25,000 to get 24,000 for EPS calculation. For weighted average outstanding shares we have added 10, 000 and 15,000 which is then divided by 2 to get 12,500.
EPS focuses on the portion of net earnings that is applicable to a single share of common stock. If the company has only equity shares, basic EPS has to be calculated. In case of a complex capital structure, where it includes convertible bonds and preferred stocks, the company reports both basic and diluted EPS. Both diluted and basic earnings per share or EPS present on the face of the income statement.
Also Read: What is diluted earnings per share
