Earnings per share (EPS) refers to a formula whereby a company’s profits or net income is divided by the number of shares outstanding. This gives you an indication of how much profit ‘per share’ is being returned to shareholders. . In this article, we explore everything you need to know about EPS.
Earnings per share (EPS) is a common metric used by many investors to help them value a company and decide whether or not to invest in it.
It’s an important concept to understand because it is also used in a number of other ways to evaluate a company’s appeal for investment. A related metric is the price-to-earnings (P/E) ratio, which we’ll talk more about later.
How to calculate EPS
The formula for calculating EPS is as follows:
Note that the calculation of EPS does not normally use the EBITDA metric, which stands for earnings before interest, taxes, depreciation, and amortisation.
We mention this because EBITDA 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.
In your research, you’ll come across companies that do not have an EPS value. This is because they are yet to turn a profit, so their EPS is effectively zero (or even a negative number). This doesn’t mean the company is broke or bankrupt! It usually means they’re in the ‘growth stage’ and focused on maximising revenue over profits.
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. Diluted EPS does the same but adds 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.
As a result, the diluted EPS metric will typically be lower than the basic EPS.. Many investors prefer to use the diluted EPS where applicable, as it is more conservative and takes into account more potential outcomes.
Why is measuring EPS important?
When analysing a company for potential investment, most investors take a long, slow look at the EPS recorded per year and how it has been changing over time.
As EPS effectively measures how much profit is returned to a company’s owners, it provides a good indication of a company’s past performance.
If a company has been growing its 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 the company has the potential to be a successful investment.
Conversely, if a company’s EPS has been going backwards in recent years, that’s normally a red flag. Sometimes, a falling EPS can be justified by extraordinary circumstances, so you’d need to do further research to discover the reasons behind it.
Other uses of EPS
EPS is also important because it is used in the calculation of other common investing metrics, such as the P/E ratio we touched on earlier..
The P/E ratio measures a company’s share price relative to its earnings per share. This is a great metric for comparing different companies in the same industry or sector.
For example, if a mining company’s P/E ratio is 15 and the mining industry’s P/E ratio is 20, this might indicate that the company is good value at its current share price.
Dividend investors, in particular, will 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 and the company pays out $1 per share in dividends, it will have a payout ratio of 50%.