Understanding EPS
Earnings per share or EPS is the portion of a company’s profit that is allocated to each individual outstanding share. In this article, we will elaborate on the methods of calculating EPS. In order to understand how to calculate EPS, we must first understand the different types of capital structures as follows.
Types of Capital Structure – Simple and Complex
A company’s capital is composed of its equity & debt. Equity can further be divided into preferred stock & common stock. In contrast, sometimes debt & other debt instruments can be converted into equity.
When a company has issued financial instruments that are potentially convertible into common stock, it is said to have a complex capital structure. If a company’s capital structure does not include such potentially convertible financial instruments, it is said to have a simple capital structure.
Understanding this differentiation in the capital structure is important as it will help us understand basic EPS & diluted EPS.
Basic EPS vs. Diluted EPS
In a company with a complex capital structure, if all the potentially convertible financial instruments are converted into common stock & then the EPS is calculated, then the resultant EPS will be diluted EPS. In contrast, a basic EPS is only for the company’s common stock (not other convertible debt). When any financial journals mention “EPS,” it usually refers to basic EPS.
Also Read: Earnings Per Share
How to Calculate EPS?
In this post, we will limit our discussion to the calculation of basic EPS.
By definition, basic EPS is the amount of income available to common shareholders divided by the weighted average number of common shares outstanding over a period. Some companies might have preferred stock. Deducting this dividend on preferred stocks from net income helps calculate basic EPS. Thus the formula of basic EPS is:
Formula
Basic EPS = (Net Income – Preferred dividends)/ Weighted average number of common shares outstanding.
- If the company doesn’t have preferred stock, then preferred dividends would be zero.
- The weighted average number of shares outstanding is a time weighting of common shares outstanding. In simple words, the shares are averaged out on the basis of how much time the shares have been outstanding.
We will be able to understand the concept better with some examples.
Examples
Example 1:
For the year ended 31 December 2017, XYZ Company had a net income of USD 2,250,000. The company had 1,000,000 shares of common stock outstanding. No repurchases or new issues, no preferred stock, & no convertible financial instruments.
Therefore, Basic EPS of XYZ Company
= (Net Income – Preferred dividends)/ Weighted average number of common shares outstanding
= (2,250,000 – 0)/ 1,000,000 = 2.25
So Basic EPS = USD 2.25 per share.
Example 2:
For the year ended 31 December 2017, ABC Company had a net income of USD 2,500,000. The company declared and paid USD 200,000 of dividends on preferred stock. The company had also made the following changes to its common stock during the year:
- Shares outstanding on 1 January 2017 (A) – 1,000,000
- New Shares issued on 1 April 2017 (B) – 200,000
- Shares repurchased on 1 October 2017 (C) – (100,000)
- Shares outstanding on 31 December 2017 (A)+(B)-(C) = 1,100,000
Step 1 – Calculating weighted average number of shares outstanding:
| 1,000,000 x (3 months/ 12 months) (Outstanding from 1 January to 31 March 2017 – 3 months) | 250,000 |
| 1,200,000 x (6 months/ 12 months) (Outstanding from 1 April to 30 September 2017 – 3 months) | 600,000 |
| 1,100,000 x (3 months/ 12 months) (Outstanding from 1 October to 31 December 2017 – 3 months) | 275,000 |
| Weighted average number of shares outstanding (250,000 + 600,000 + 275,000) | 1,125,000 |
Step 2 – Calculating Basic EPS of ABC Company
= (Net Income – Preferred dividends)/ Weighted average number of common shares outstanding
= (2,500,000 – 200,000)/ 1,125,000 = 2.04
So Basic EPS of ABC Company = USD 2.04 per share
Thus we can interpret it as, for every common share the company has outstanding, the company has earned USD 2.04.
You can also use our Calculator for Calculating EPS.
Interpretation of EPS
Usually, investors believe that the higher the EPS, the better. This is true to an extent as the higher the EPS, the more profitable the company is, and there are higher chances that the company will pay out higher dividends on common stock. But it is important to understand that EPS, as a measure by itself, will not give any definitive indication of the company’s financial health. Hence the question arises what is a good EPS?
Also Read: Basic vs Diluted EPS – All You Need To Know
To establish the strength of EPS, analysts compare the present EPS with that of the historical EPS of the same company. For example, the basic EPS of Apple Inc. was USD 8.35 in September 2016 & USD 9.27 in September 2017, which means the company’s profitability increased. Furthermore, the analysts also compare a company’s EPS with that of its competitors to understand its standing in the market. Thus we can conclude that all other things equal, a company with higher EPS is more profitable & financially strong.
You can also refer to EARNINGS PER SHARE.
