Earnings per share is an important metric which is used to identify a company’s earnings. It is calculated by dividing a company’s profit by its common stock’s outstanding shares. This is considered to be a significant factor as it provides a brief insight into the company’s profitability.
In simple terms, EPS tells how much money a company makes for each share and is primarily used to measure the company’s financial health. Increasing EPS reflects higher profitability and vice versa.
How is EPS Calculated?
Here is how EPS is calculated:
EPS = Net Income – Preferred Dividends / End-of-period common shares outstanding
For instance, a company ABC Ltd has a net income of Rs 12 lakh and announces 2 lakh as preferred dividends and has 5 lakh common shares outstanding (weighted average).
Hence the EPS of the company ABC ltd as per earnings per share formula would be:
EPS = Rs (1000000 – 200000)/ 500000
= Rs 2 per share.
You may not know but the company’s balance sheet and income statement are based on EPS calculations. It is recommended to use a weighted average number of outstanding shares as the actual number of shares may vary over a period of time.
It should be noted that the dividends earned on cumulative preferred stocks and non-cumulative preferred stocks affect the EPS results differently. For example, the dividend on cumulative preferred stock for the current period is subtracted from the net income.
The EPS is considered as one of the important factors to identify a stock’s price. It is also an essential component used for calculating price to earnings P/E ratio, which measures a company’s value as a factor of its current share price relative to its EPS.
In P/E ratio, the E stands for EPS. If you divide a company’s stock price by its EPS, investors can calculate the share value in terms of how much the stock market can afford to pay for each earned Rupee.
Types of Earnings Per Share
Although there are numerous variations of earnings per share and each of them tends to signify a different aspect of the financial parameter.
Importance of Earnings Per Share
Earnings per share play an important role in measuring a company’s profitability and financial standing. There are several points investors need to know about earnings per share.
As discussed above, EPS depicts the profitability of a company, which in turn suggests that the company may increase its high dividend payout ratio.
EPS helps companies to compare the performances with their respective competitors.
With EPS, investors can easily determine the company’s current and anticipated stock’s value. Also, it helps investors to analyse whether the stock price is valued according to market performance and stock market research.
Limitations of Earnings Per Share
Although earnings per share are known to be a potential financial tool, investors need to understand that EPS has its share of drawbacks.
Here are the limitations of earnings per share:
- Most business owners can manipulate EPS by minimizing the number of outstanding shares by buying back their shares.
- EPS per share does not capture the performance of a company. However, many such attempts are completely apt for short term which hampers the venture of the business.
- Since EPS does not consider inflation, the growth indicated by it may not be accurate in the first place. For example, the overall price of goods and services also increases.
- Cash flow is an important term when it comes to measuring a company’s ability to repay its debt. However, cash flow is not factored in EPS calculation which means a high EPS may still prove ineffective for gauging a company’s solvency.