When investing in shares, profitability is an important factor to consider. It is the goal of every investor to make a profit from their investments in a company’s stock. Without profit, investment doesn’t make sense, does it? Therefore, a useful measure to understand the profitability of a company is to calculate its earnings per share or EPS.
Consequently, investors and companies have been touting it as the holy grail of financial performance for a very long time. Investors use this metric to compare companies and determine which ones are more profitable. They also determine which ones potentially offer a higher return on investment. In this blog, we will delve into the concept of EPS in stock market and explore its significance in financial analysis.
What is EPS (Earnings Per Share)?
EPS or Earnings Per Share is a financial metric that is widely used to assess a company’s profitability and performance. It is an essential component of the financial statements that investors and analysts use to evaluate a company’s worth and make investment decisions. A company earns a measure of profit for each share of common stock outstanding.
In the share market, people commonly use it to evaluate a company’s worth and make investment decisions. Companies with high EPS stocks are often seen as more profitable by investors like you, who may be attracted to them as they offer a higher return on investment. Thus, investors and analysts use this metric to compare companies within the same industry or sector. They use EPS to determine which ones are more profitable. It is also useful in identifying high EPS stocks that have the potential to provide higher returns.
One can use it in conjunction with other financial metrics, such as the Price to Earnings (P/E) ratio. This can be done to determine a company’s value and growth potential. Thus, you can use this metric to compare companies within the same industry. Also, you can identify potential investment opportunities. Additionally, it affects the market price of shares, so an increase in total corporate value follows.
What is EPS Ratio?
The price-to-earnings (P/E) ratio, also known as the EPS ratio. It calculates the relative value of a company’s shares based on its earnings per share and is used in the stock market.
To calculate the Price Earnings (P/E) ratio, one divides the earnings per share of a company by its current market price. This ratio allows for a comparison of a company’s valuation with its competitors, industry average, or historical data.
If a company has a current market price of ₹100 and an EPS of ₹10, the EPS ratio would be 10 (₹100 / ₹10). This means that investors are willing to pay 10 times the company’s earnings per share for its shares.
A high EPS ratio can indicate that investors have overvalued a company. On the other hand, a low EPS ratio can indicate that investors have undervalued a company. However, it’s important to consider other factors as well. Such as a company’s debt, cash flow, and future growth potential before making investment decisions.
Calculation of Earnings Per Share
Companies use Earnings Per Share as a key financial metric to assess their profitability and financial health. They calculate it by dividing the earnings available to common shareholders by the Weighted Average Number of Shares Outstanding.
Investors and analysts use this metric to compare companies, identify high EPS stocks, and make informed investment decisions.
In a nutshell, the EPS formula is:
|Earnings Per Share = Net Income − Preferred Dividends / End-of-Period Common Shares Outstanding|
In order to determine a company’s this metric, the balance sheet and income statement are used, along with dividends paid on preferred shares (if any) and net income. We subtract preferred dividends from net income since it refers to earnings available to common shareholders. Therefore, it is important to note that no deduction from net income for dividends paid on common stocks.
Thus, higher the EPS, more likely it becomes suitable for investing.
Calculate earnings per share using Excel
To calculate Earnings Per Share in Excel, you will need to input the following information:
- Net Income
- Preferred Dividends (if any)
- Weighted Average Number of Shares Outstanding
Once you have inputted the necessary information, follow these steps:
1. Subtract the Preferred Dividends from the Net Income to arrive at the earnings available to common shareholders.
2. Calculate the Weighted Average Number of Shares Outstanding by multiplying the number of shares outstanding in each period by the number of days in the period, then adding up the totals and dividing by the total number of days in the period.
3. Divide the earnings available to common shareholders by the Weighted Average Number of Shares Outstanding to arrive at the Earnings Per Share.
Earnings Per Share Example
Let’s assume that Peter has decided to invest in either Ali’s Ice Cream or Ed’s Carpet and is confused about which one to choose. To help him make a decision, Peter decides to compare the earnings per share of both companies.
Ali’s Ice Cream
After doing some research, Peter finds out that Ali’s Ice Cream reported a net income of ₹10 crores for the fiscal year, and has 2 crore outstanding shares.
EPS for Ali’s Ice Cream = Net Income / Average number of outstanding shares
= 10 Crore / 2 crore shares
= ₹5 per share
Similarly, Peter finds out that Ed’s Carpet reported a net income of ₹8 crore for the fiscal year, and has 4 crore outstanding shares.
EPS for Ed’s Carpet = Net Income / Average number of outstanding shares
= ₹8 crore / 4 crore shares
= ₹2 per share
From this analysis, Peter can see that Ali’s Ice Cream company has a higher EPS of ₹5 per share. However, Peter should conduct further research and analysis to make an informed decision about which company to invest in.
Types of EPS
There are two different types of earnings per share: Basic and Diluted EPS. Basic is a calculation that uses the net income of a company divided by the total number of outstanding shares to determine the earnings per share. However, Diluted EPS is a calculation that takes into account all potentially dilutive securities that could be converted into diluted earnings per share.
(Note: Diluted EPS is usually lower than basic EPS because it considers the impact of potentially dilutive securities.)
List of two distinct earnings per share.
|Definition||A calculation that uses the net income of a company divided by the total number of outstanding shares to determine the earnings per share.||A calculation that takes into account all potentially dilutive securities that could be converted into shares such as stock options, convertible bonds, and other securities that could be converted into shares in the future.|
|Formula||Basic EPS formula:|
Net Income / Total Outstanding Shares
|Diluted EPS formula:|
Net Income / (Total Outstanding Shares + Potential Dilutive Securities)
|Considerations||Only takes into account the number of outstanding shares||Takes into account potentially dilutive securities that could be converted into shares|
|Impact||Basic EPS is usually higher than diluted EPS||Diluted EPS is usually lower than basic EPS|
|Usefulness||Used to assess a company’s profitability and potential for growth||Used to provide a more accurate picture of a company’s earnings per share, as it takes into account potentially dilutive securities.|
|Importance||One of the most commonly used metrics in the share market||Used to determine the true earnings power of a company and its growth potential.|
EPS Calculation: Basic and Diluted
Let’s assume a company has a net income of ₹100,000 and 10,000 outstanding shares. The company also has 2,000 potentially dilutive securities in the form of stock options and
Basic EPS Calculation:
Basic EPS formula = Net Income / Total Outstanding Shares
= ₹100,000 / 10,000 = ₹10 per share
Diluted EPS Calculation:
Diluted EPS formula = Net Income / (Total Outstanding Shares + Potential Dilutive Securities)
= ₹100,000 / (10,000 + 2,000) = ₹7.69 per share
In this example, ₹10 is the Basic EPS per share and ₹7.69 is the diluted earnings per share. This means that the Diluted EPS takes into account the impact of potentially dilutive securities, resulting in a lower EPS than the Basic EPS.
Factors that Impact the Earnings Per Share
Earnings Per Share can be impacted by a variety of factors. Here are some of the key factors that can impact earnings per share:
- Changes in Net Income: Net income is the main driver of EPS, so any changes in the company’s profitability will impact EPS. If a company’s net income increases, it will increase, and vice versa.
- Changes in the Number of Shares Outstanding: It is calculated by dividing net income by the number of outstanding shares. Therefore, any changes in the number of shares outstanding, such as through stock issuances or share buybacks, will impact earnings per share.
- Changes in Dividends: Dividends are payments made to shareholders out of a company’s profits. If a company increases its dividend payout, this will reduce the retained earnings that could be used to increase net income and, therefore, reduce EPS.
- Stock Buybacks: Stock buybacks occur when a company repurchases its shares from the market. This reduces the number of outstanding shares, which can increase EPS. However, it’s important to note that while EPS may increase, the company’s overall profitability is not affected by stock buybacks.
Interpretation of Earnings Per Share
Here are some key points to keep in mind when interpreting EPS:
- Higher EPS: A higher EPS indicates that a company is more profitable and generates more earnings per share. It’s important to note that factors such as changes in net income, changes in the number of shares outstanding, changes in dividends, and stock buybacks can impact EPS. Therefore, it’s important to consider these factors when interpreting EPS.
- Comparison to Industry Standards and Competitors: It can be useful to compare a company’s EPS in stock market to industry standards and competitors. It gives a sense of how well the company is performing relative to others in the same industry. However, it’s important to consider other factors before making investment decisions based solely on earnings per share comparisons.
- Potential Limitations: You should be aware of the potential limitations of EPS as a metric. Earnings per share can be manipulated by accounting practices and changes in the number of outstanding shares, so it’s important to consider other financial metrics in addition to earnings per share when evaluating a company’s performance.
- Historical Trends: Analyzing a company’s earnings per share over time can provide insight into its growth and profitability trends. Consistent growth in EPS in share market can be a positive sign, while a decline in EPS in share market over time may be cause for concern.
Limitations of Earnings Per Share
Despite its widespread use, there are some limitations to using Earnings per Share as a financial metric in the stock market. In this section, we will discuss three main limitations.
- Can be Manipulated: Companies have the ability to manipulate their earnings to achieve a certain EPS level. This can be done through accounting adjustments, aggressive revenue recognition, or expense deferral. Therefore, investors and analysts should be cautious when relying solely on EPS.
- Doesn’t Consider Inflation: We calculate Earnings Per Share based on current earnings, and we do not account for inflation. This means that earnings per share can be misleading over the long term since it doesn’t reflect the impact of inflation on a company’s financial performance.
- Does Not Reflect the Quality of Earnings: EPS does not provide information about the quality of earnings, such as whether the earnings are sustainable or whether they are generated from the company’s core operations.
To Wrap It Up…
Earnings per share or EPS in share market is a profitability measure that investors define as the value of earnings per outstanding share of common stock. Generally, it is advisable to look for companies with higher EPS stocks, however, one should consider other factors specific to the company.
Overall, you should consider Earnings Per Share as an important metric when evaluating a company’s profitability and potential for growth. You should also consider it in conjunction with other financial metrics of the company.
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