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Investment 101: Finding the Right EPS

If you’re looking for the best way to invest your money, the share market is always a tempting option. But you can go drastically wrong if you don’t know what you’re doing. Welcome to Investment 101, an article series dedicated to helping the newbie investor find their feet in the share market.

In this article, we will discuss one of the most important aspects of a share: Earnings Per Share (EPS).It denotes the income earned by the company per share of outstanding stock. To put it in simple terms, it is the monetary amount that a stockholder will get if the company hypothetically distributes its earnings amongst the holders of the outstanding stock.

The measurement of EPS also signals the profitability of the company as a whole. High EPS values indicate better profitability and low EPS values indicate limited to no profitability of the concerned company. However, you must consider the difference in outstanding shares before making any comparison about the profitability of different companies based on EPS.

Here’s what you will find in this article:

  1. Formula for EPS
  2. Types of EPS
  3. How to Use EPS
  4. Significance of EPS
  5. Limitations of EPS

Let’s get to it!

Formula for EPS

To arrive at the EPS of a company, identify the net profits earned that are available for the common stockholders. Calculate the EPS by subtracting the preference dividend from the amount of post-tax income earned by the company. To calculate EPS, such net income is to be divided by the number of common stock outstanding at the year-end.

The formula for calculating EPS is represented as below:

The calculation is based on information contained in the income statement and the balance sheet of the company. It is sometimes more appropriate to use the weighted average of common stock over the period under consideration. This is because the number of outstanding shares may change significantly over the given period. This may be due to various reasons such as buyback of shares, fresh issue of shares, and so on.

As an investor you might be having easy access to the parameters required for arriving at EPS. So, if you want to know the EPS of a stock of any listed company, you may refer to websites such as Morningstar Inc.which provides you with this information, along with other useful insights about the company.

Practical Example

Suppose there is a company that has reported the following details as a part of its financial statements.

Earnings before tax $54,000
Tax $18,000
Net Income $36,000
Capital Stock (6,000 shares of $10 each) $60,000
Preference Dividend $3,000

Now, applying the above formula, EPS can be calculated as follows:

In this example, EPS comes out to be $5.5.

Types of EPS

You may come across two types of EPS in the financial statements of any company, namely Basic EPS and Diluted EPS.  Now let us understand how they are different from each other.

Basic EPS

It refers to the EPS that we have discussed so far, indicating the net income available per share of outstanding common stock. Basic EPS is calculated by dividing the earnings available for common stockholders by the number of outstanding common shares.

Diluted EPS

Diluted EPS is a complex financial measure, which represents the EPS of the company after taking into account the dilution effect of shares that a company could issue. In other words, it reflects earnings per share in a case where all convertible securities (such as convertible preference shares, convertible debentures, ESOPs, etc.) are exercised. It generally follows that Diluted EPS comes out to be lower than Basic EPS.

How to Use Earnings Per Share

If you are an investor or a market analyst, EPS may be a useful analysis tool for you. EPS is of great importance for long-term investors as compared to day traders. You may use this financial measure in the following manner to draw out the following meaningful analytics:

  • Use EPS in conjunction with Price/Earnings Ratio (P/E Ratio) for comparing the performance of two or more companies of similar nature and size and operating in a similar industry. Further, you may analyze whether the EPS is on an upward or a downward trend over time to understand whether trading in such stock is a good idea.
  • P/E ratio derives its value by dividing the market price by EPS of the stock. It is a very useful ratio as it helps the investors to evaluate the worth of return that a stock yields on its investment.
  • The EPS figure is also used by the general public as a criterion for the selection of stocks. If you are interested in investing, you may choose a mentor or a broker for yourself who can help you meet your trading objectives.

Significance of EPS

Earnings per share is an indicator of the financial health of the company. An increasing EPS will reflect that the company is performing well financially. Further, EPS indicates the amount of earnings attributable to each outstanding share. It comes out to be one of the important factors in the evaluation of the price of a stock.

EPS is widely used by investors to evaluate the performance of stocks of two or more companies and accordingly, make an investment decision. Being an investor, you should keep an eye upon the EPS disclosed in the quarterly financial results of the companies.  Apart from the financial results, stay updated with the current news relating to the stocks with the help of One Billion Signals, a fin-tech app that notifies a user about the latest news in the stock market. It will help you to evaluate your investment.

Limitations of EPS

Although EPS is an important financial tool for investors, we must not ignore the limitations attached to it.

  • We must not use EPS alone as a decisive factor in making investment decisions. It is important to analyze other factors too, such as P/E Ratio, to have better clarity about the stock position. If you are a beginner in the stock market, you may take help of demo accounts and carry out trading activity there by applying these factors, before you actually move on to the actual platform. Talking demo account, Algo Signals (Italy) provides an opportunity to the users to access demo trading accounts with virtual money of $1,500.
  • Sometimes, the company management intentionally takes decisions to reflect a higher EPS for a short period. This increases the share prices of the company. In such cases, the manipulated EPS becomes misleading for the investors.
  • Different companies may be subjected to different sets of accounting policies. As a result, making comparisons amongst companies based on EPS may become difficult.

We have seen that EPS can prove to be a significant factor for investors when used in conjunction with P/E Ratio. It is also important that we select those companies for analysis that have a clear corporate governance background to ensure that there are the least chances that earnings or outstanding shares are manipulated to reflect a higher EPS at year-end. When used carefully, EPS can be a powerful tool to help you invest better.