Earnings Per Share Ratio
This is a complete guide on how to calculate Earnings Per Share Ratio (EPS) with detailed analysis, interpretation, and example. You will learn how to use its formula to determine if a company is currently cheap or expensive.
Definition - What is Earnings Per Share Ratio?
Also going under the name of “income per share” or “EPS,” the earnings per share is a prospect ratio of the market that calculates the net income which was earned per share over a period.
The EPS declared by a company is a great indication of how profitable it is.
It’s basically the amount of money a company earns during a specific period, portioned out in terms of each outstanding share of common stock.
Simply put, this money is what any shareholders would receive for each common share they own if the profits were to be distributed by the company.
The earning per share also shows how much profit your company brings on a shareholder basis. Therefore, if we have a larger company and a smaller company, their profits can easily be compared.
Of course, all these calculations are greatly influenced by the number of outstanding shares. So, if you have a larger company, you would be required to split its profit amongst different shares.
Earnings per share ratio is calculated as you subtract the preferred stock dividends from net income, and then divide it by the combination of common stock equivalents and all outstanding common shares.
The formula will, therefore, look something like this:
Earnings per Share = Net Income - Preferred Dividends / Average Number of Shares Outstanding
The EPS generally measures the income that is available to the common stockholders. It’s normally declared and reported by a company on a quarterly and yearly basis.
The preferred dividends, therefore, are shifted towards the preferred shareholders – and thus, they can’t mix.
Besides, you can come up with a more precise result if you use a weighted average number of shares outstanding when calculating the EPS.
That’s because the company’s capital structure can change from time to time, and that also leads to a change in outstanding shares number.
If a firm employs a more complicated capital structure, it’s required to report two EPS figures: basic EPS and diluted EPS.
Diluted EPS expands on basic EPS by adding the shares of warrants and convertibles outstanding to the number of shares outstanding if these convertible securities were exercised.
The formula for calculating diluted earnings per share looks like this:
Diluted EPS = (Net Income - Preferred Dividends) / (Shares Outstanding + Diluted Shares)
You can easily find all of these figures on a company’s financial statements.
Okay now let’s consider a quick example so you understand clearly what this ratio is about and how it can help you in making your investment decision.
Let’s say that we have Company C that has a net income that is around $50,000 per year.
Considering that the firm is small, we don’t have any preferred shares outstanding.
The shares of common stock during the year will be 100,000. Therefore, the formula is calculated this way:
You can see that Company C’s net income per share is $0.5. This means that if we divide the entire income to all shareholders, each of them would get $0.5.
Or in other words, the shareholders will receive $0.50 per every $1.00 they invested into this company.
Interpretation & Analysis
The income per share concept is very similar to market prospect or profitability ratio.
A higher earnings is always preferable to a low ratio. It proves that the company that you are investing in brings more profit, and it can, later on, distribute more value to the shareholders.
In truth, not many investors pay enough attention to the net income per share – even though a higher EPS ratio would make a company’s stock prices go up.
So what is a good earnings per share ratio?
In short, the higher the earnings per share ratio, the better. A consistent growth in EPS is a positive sign that the company’s management is doing a great job to provide more shareholders value.
This ratio is also useful when you use it to compare a company with its competitors and the industry averages.
By doing so, you can easily determine which company is doing better in providing value for their shareholders.
It’s worth noting that two different companies in the same industry could create the same EPS, but one of them could possibly do much better than the other with less shareholders’ capital.
As an investor, obviously you will want to put your money in the better company since it provides you higher value, and of course higher profits in the long run.
Cautions & Further Explanation
Keep in mind that the net income is a very important aspect to the ratio.
Although it indicates the general operating conditions of your company, it can be heavily influenced by non-operating credits or charges – things that will prevent revealing the cash position of your firm.
As a result, you have to mix it with an analysis of the operating results, as well as a careful analysis of the cash outflow and inflow.
Be mindful that a number of stock equivalents tend to be sometimes overstated; if this happens, it will artificially reduce the EPS amount.
Considering that there are many factors that can manipulate the ratio, most investors would give it a glance but not allow it to influence their decisions greatly. So don’t make that mistake!