Earnings per share (EPS) is a common metric used by many investors in the course of company valuation on the share market. It’s an important concept to be across, because EPS is used in a number of other formulas and metrics, such as the price-to-earnings (P/E) ratio, that are also commonly used by investors.
What is earnings per share (EPS)?
The phrase ‘earnings per share’ actually refers to a formula, whereby a company’s profits or net income is divided by the number of shares outstanding. So in essence, you take a company’s total profit and divide it amongst every share of the company. This gives you an indication of how much profit ‘per share’ is being returned to its owners.
It’s also worth pointing out that not all companies will have a value for their EPS. If a company is yet to turn a profit, then it will have an EPS of zero (or even a negative number). This doesn’t mean the company is broke or bankrupt though, as many companies in the ‘growth stage’ will focus on maximising revenue over profits.
How to calculate EPS
The formula for calculating EPS is as follows:
Note that calculation of EPS does not normally use the EBITDA metric. EBITDA (sometimes EBIT) stands for earnings before interest, taxation, depreciation and amortisation and is a common substitute for ‘earnings’ in other contexts. However, calculating a company’s EPS normally uses net income, which includes the costs listed above that the EBITDA metric discards.
Basic EPS vs. Diluted EPS
There are two types of EPS numbers that investors like to look at when analysing a company: basic EPS and diluted EPS. They are similar in that they both use the above formula for calculation. However, there is one significant difference. Basic EPS takes into account all shares currently outstanding, as per the formula above.
However, diluted EPS also takes into account any shares that the company might have quarantined for items such as share options, warrants, or shares allocated to management or employees as part of their remuneration. The diluted EPS metric assumes that all of these shares are issued, as per the formula below:
As such, the diluted EPS metric will typically be lower than the basic EPS metric as a result of including these ‘unissued’ shares in the overall share count. Many investors prefer to use the ‘diluted EPS’ metric where applicable as it is more conservative and takes into account more potential outcomes.
Why is measuring EPS important?
When analysing a company for a potential investment, most investors would take a long, slow look at a company’s EPS and how it has been growing over time. As EPS effectively measures how much profit is returned to a company’s owners, it’s an important metric to use if we want to examine a company’s past performance. If a company has been growing EPS at a healthy rate in recent years, it’s normally a good indication it will continue to do so into the future. This would indicate it has the potential to be a successful investment.
Conversely, if a company’s EPS has been going backward in recent years, that’s normally a red flag for a potential investment and would need to be justified by extraordinary circumstances in order to make a positive bull case.
Other uses of EPS
EPS is also an important number, as many other common investing metrics include this number in the calculation of other useful ratios. We touched on the P/E ratio earlier, which measures a company’s share price relative to the company’s earnings per share. This is a great metric for comparing different companies in the same industry or sector.
But dividend investors in particular might also be familiar with the payout ratio. This ratio measures how much of a company’s earnings are paid out in dividends each year. For example, if a company’s EPS is $2 per share and the company pays out $1 per share in dividends, it will have a payout ratio of 50%. As such, it is important to know a company’s EPS as it helps put other metrics into perspective.