Earnings per Share (EPS) is a financial metric that measures the portion of a company’s profit allocated to each outstanding share of its common stock. EPS is a critical indicator of a company’s profitability and is widely used by investors, analysts, and financial professionals when assessing a company’s financial health and performance.
The formula to calculate Earnings per Share is as follows:
EPS = (Net Income – Preferred Dividends) / Weighted Average Number of Common Shares Outstanding
Let’s break down this formula:
- Net Income: Net income represents the company’s total profit after all expenses, taxes, and interest have been deducted. It’s often found on the income statement.
- Preferred Dividends: Some companies issue preferred stock with the obligation to pay dividends to preferred shareholders before common shareholders. Subtract these preferred dividends from net income to determine the portion of earnings available to common shareholders.
- Weighted Average Number of Common Shares Outstanding: This number accounts for any changes in the number of common shares outstanding throughout the reporting period. To calculate this, you take the weighted average of the beginning and ending common shares outstanding during the period.
The resulting EPS figure represents how much profit each common share would receive if the company distributed all its earnings to common shareholders.
EPS is reported in two primary forms:
1. Basic EPS: This calculation considers only the actual common shares outstanding without considering the impact of potentially dilutive securities like stock options or convertible bonds.
2. Diluted EPS: Diluted EPS takes into account the potential dilution from securities like stock options, convertible bonds, and other convertible instruments that could be converted into common shares. It assumes that these securities are exercised or converted and the shares are added to the weighted average common shares outstanding if it’s dilutive.
EPS is essential for several reasons:
- Investment Decisions: Investors use EPS to gauge a company’s profitability and to compare it with other companies in the same industry.
- Stock Valuation: EPS is often used in various valuation methods, such as the Price-to-Earnings (P/E) ratio, to assess whether a stock is overvalued or undervalued.
- Financial Performance: Companies use EPS to report their financial performance to shareholders and regulators.
- Executive Compensation: Many executive compensation plans include performance-based stock options, and EPS is a common metric used to determine eligibility for such options.
It’s important to remember that EPS is just one of many financial metrics that should be considered when evaluating a company. Additionally, companies may use different accounting methods and have various non-recurring items that can affect EPS, so analysts often consider adjusted or normalized EPS figures to make more accurate comparisons.