Earning Per Share: Meaning, Types, Steps for Calculation, Importance and Limitations

Meaning

Earning per share (EPS) refer to portion of company’s profit available to each share of stock. It defines the amount that will be paid on per share basis out of total net profit earned by company. EPS is an important financial metric used for analysing the ability of company to generate net profit for its group of shareholders. This parameter conveys a lot of information regarding company such as its current and future profit earning potential. Earning per share is simply computed by dividing the total profit generated within a particular period of time with number of shares listed by company on stock market. Overall, the EPS denotes value affixed to every outstanding stock of organisation. 

Investors majorly use EPS parameter for determining the value of company as it helps them in measuring profitability on per share basis. A higher EPS denotes that company is more profitable and has more profits for distributing among its shareholders. Whereas, a negative EPS reflects bad image of company that means its earning is in negative and company is losing or spending more money than what it earns. The EPS of company is primarily influenced by 2 factors that are: income level of company and number of its common shares outstanding. With share being constant, any increase in income would increase EPS whereas any decrease in income would lead to decrease in EPS. 

Types of Earning per share (EPS) 

Earning per share is generally of three types based on the source from where numbers came. These types are: – 

  1. Trailing EPS: Trailing EPS is one that form its basis on numbers from previous years. The computation of earning per share is done by utilizing the earnings from previous four quarters. This type of EPS is mostly used by stock market values due to its nature of using actual figures. However, trailing EPS is not of much scope for investors as it does not project the future EPS figures.  
  2. Current EPS: The current EPS is based on current year numbers that include projections. This type of calculation utilizes figure from four quarter of current fiscal year. Some of quarters have already passed thereby providing the actual figures, while some of the quarter remain in projections. 
  3. Forward EPS: The EPS based on future projected numbers is termed as forward EPS. Company itself or analyst often make forward projections for investors, who are looking to find out earning capacity of company.

Basic EPS vs Diluted EPS

Basic and Diluted EPS are two other types of earning per share. Basic EPS means the amount of company earnings that are attributable to each of common share. On the other hand, diluted EPS means the amount of earnings relatable to common shareholder under a hypothetical scenario where all dilutive securities are transformed into common shares. Reporting of basic EPS helps in doing the earning comparison among distinct companies, whereas diluted EPS reporting is needed for reducing the moral hazard issues. In absence of diluted EPS, management can easily mislead the shareholders with regard to the profit earning potential of company. The value of basic EPS is always greater than the diluted EPS.

What is Good EPS?

An EPS is either good or bad is dependent upon multiple factors such as company’s recent performance or the performance of its competitors/industry. The goodness of EPS is less determined by its absolute value but more from its year-on-year change. Absolute value of company EPS should increase annually, but the rate of increase in EPS should also accelerate. Earnings per share of company can vary on the basis of fluctuations in earnings and total number of outstanding shares, or both. It can be boosted via enhancing its level of earnings or reducing its count of shares through share buybacks. However, a company increasing its outstanding share count faster then its earnings will cause drop in its EPS. 

The Earning per share can be evaluated further by stock investors via considering it in conjunction with its P/E ratio and finding out how the price of company’s share is varying in relation to its earnings.  

Steps for the computation of EPS

There are basically 2 ways of computing EPS that are using the basic earnings per share equation and weighted earnings per share equation. The steps for calculating earning per share using both of these ways are explained below.

Steps to Compute basic earnings per share 

  1. Determining net income of company from previous year- A most basic way to find EPS is utilizing the net income of company for primary number. This information is generally available on their website or on financial webpage. Always be cautious of not mistakenly considering quarterly net income for annual. 
  2. Determining the number of outstanding shares- The number of shares that company has on stock exchange are called outstanding shares. Such information should be made available for public viewing by financial websites.
  3. Dividing the net income with number of outstanding shares- In order to find out the basic earnings per share, it is simply required to divide net annual income of previous year by total number of shares outstanding. 

Here is a short and simple example of basic EPS computation- The net income of company from FY 2019 is 5 billion dollars and it has around 1 billion shares outstanding. The basic earning per share in this case will be 5 billion / 1 billion that is 5. 

Steps to Compute Weighted Earnings per Share

Weighted earnings per share is considered as more accurate way of computing EPS as dividends are consider under it, also called preferred stocks issued by company to its stockholders. A dividend represents the amount paid by company out of its profit earned to shareholders, usually on quarter basis. The steps to calculate are: 

  1. Determining the dividend of company on preferred stocks- This type of information is usually found on website of company or financial webpage. 
  2. Subtracting the company’s dividend from its net annual income- The amount of dividend can’t be included into annual net income as it is paid out by company to shareholders.  
  3. Dividing the difference with average amount of shares outstanding- Now similar to the calculation of basic earning per share, the number of shares is subtracted from the annual net income (without dividends).

An example of weighted EPS calculation: – The net income of company from FY 2019 is 15 billion dollars and dividend amounting to 2 billion is paid to shareholders over the course of year. Company has 4 billion outstanding shares. 

The weighted earning per share = (15 billion – 2 billion) / 4 billion

                                                          = 13 billion / 4 billion = 3.25

Importance of Earning per Share

The below mentioned points explains how crucial role does earning per share plays in evaluating the profitability and financial standing of companies: 

  • Earning per share enable in easy gauging whether a particular company would enable investors in generating more income or not. In simple terms, if company has higher EPS, then it indicates that it has a profitable status. It also suggests that company may increase the dividend pay-out over time.
  • EPS also help investor in doing the proper performance comparison of promising companies with other one. This facilitates in picking up the most suitable investment option. 
  •  Peoples are able to determine the existing and anticipated stock value of company using EPS investors and other distinct financial methods. The investors are able to analyse stock price according to the market performance. 
  • Not only the present financial status of company can be measured using EPS, but is also helps in tracking its past performances. Like for example, a company having steading increasing EPS is treated as more reliable option of investment. In the similar manner, companies having irregular EPS are generally not preferred by seasoned investors. 

Limitations of Earning per Share 

Earning per share also carries drawbacks despite of being considered as potential financial tool. The points mentioned below highlights some of its drawbacks that need to be remembered by both business owners and investors: 

  • Manytimes the EPS is manipulated by business owners in order to project their venture as more profitable one. However, such unethical attempts are carried out for short-term that eventually have negative impacts on profitability and image of particular business venture in the long run. 
  • The EPS does not take into account the effect of inflation due to which the growth indicated by it may not be accurate at all. For example, inflation leads to increase in overall price of goods and services. This way the EPS projects a misleading value, in case if venture fails to purchase or sell more of the goods than it has done a year ago.
  • In order to examine the ability of company to pay back its debt, cash flow is considered as important aspect. But cash flow is not taken into account while doing EPS calculation that means even high EPS can prove to be ineffective for gauging the solvency of company. 

Therefore, investors should also evaluate other key factors prior to judging the merit of company as an investment option. In fact, the Earning per share should be aligned with other financial parameters for getting clearer picture of overall scope, market performance and profitability of business venture. 

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