EPS is a critical indicator for investors and analysts because:
Profitability assessment: It provides insights into a company's ability to generate profits.
Comparison tool: EPS allows for easy comparison of a company's performance with its competitors.
Share price valuation: Investors use EPS to determine the fair market value of a company's shares.
Investment decisions: It plays a crucial role in investment decisions, as investors often consider a company's EPS growth over time.
Types of earnings per share
Earnings per share (EPS) exhibits various calculations, each highlighting a distinct facet of this financial metric. The specific EPS used can influence a company's stock valuation, potentially indicating undervaluation or overvaluation. The following are the different types of earnings per share:
1. Reported EPS or GAAP EPS
Reported EPS, often referred to as GAAP EPS, is the Earnings Per Share calculated following the principles and guidelines established by generally accepted accounting principles (GAAP). GAAP is a standardized set of accounting rules and procedures that companies use to prepare their financial statements. Reported EPS provides a transparent and consistent measure of a company's financial performance based on recognized accounting standards. It is calculated as follows:
Reported EPS = (Net Income - Preferred Dividends) / Weighted Average Common Shares Outstanding
2. Ongoing EPS or Pro forma EPS
Ongoing EPS, also known as Pro Forma EPS, is a modified measure of earnings that excludes one-time or non-recurring items from a company's financial statements. This type of EPS provides a more accurate picture of a company's recurring or sustainable earnings by adjusting for unusual or non-operational events, such as restructuring charges or gains from asset sales. It helps investors assess a company's core profitability. It is calculated as follows:
Ongoing EPS = (Net income - Preferred dividends - One-time gains) / Weighted average common shares outstanding
3. Retained EPS
Retained earnings are the portion of a company’s net income that is not distributed as dividends to shareholders but instead is reserved for reinvestment back into the business. It is calculated as follows:
Retained EPS = (Net earnings + current retained earnings) – Dividend paid} / Weighted Average Common Shares Outstanding
4. Cash EPS
This variation measures the amount of cash generated by a company’s operations per share of outstanding stock. It is calculated as follows:
Cash EPS = Operating cash flow / Diluted shares outstanding
5. Book value EPS
Book Value EPS is a metric that calculates earnings per share based on a company's book value. Book value is the difference between a company's total assets and total liabilities, representing the net asset value of the business. It is calculated as follows:
Book value EPS = (Total equity - Preferred equity) / Weighted average common shares outstanding
How is EPS used?
Earnings per share is a vital financial measure that is relied on to understand the absolute profitability of a company. EPS is also critical for calculating the price-to-earnings (P/E) ratio. Literally, the ‘E’ in P/E is the EPS value.
When the price of a company’s share is divided by the EPS, investors and traders can derive insights about the value of the stock in terms of the market readiness to pay for each rupee of earnings. EPS is directly useful for investors when choosing stocks for their portfolios.
Investors may find comparing EPS by itself less useful since shareholders do not directly receive these earnings. Instead, what is more helpful is comparing EPS with a given stock's price to gauge the value of the earnings and anticipate future growth potential.
Diluted EPS vs. Basic EPS
Diluted EPS and Basic EPS are two profitability measures used in the fundamental analysis of companies. Basic EPS is calculated by dividing a company's net income after taxes by its weighted average shares outstanding during a specific period. Diluted EPS, on the other hand, accounts for all potential dilution that could occur from stock-based compensation, warrants, convertible securities, and other dilutive instruments.
Dilutive effects occur when the number of shares increases—for example, through a new share issue. If a company issues more shares to investors, then this increases the number of shares outstanding and decreases the company's EPS. Diluted EPS considers all convertible securities, such as convertible bonds or convertible preferred stock, which are changed into equity or common stock. Diluted EPS is always less than its basic EPS.
To calculate a company's basic EPS, take a company's net income and subtract any preferred dividends, then divide the result by the weighted average number of common shares outstanding. The weighted average is a measurement that investors use to monitor the cost basis on shares accumulated over a period of years.
To calculate diluted EPS, take a company's net income and subtract any preferred dividends, then divide the result by the sum of the weighted average number of shares outstanding and dilutive shares (convertible preferred shares, options, warrants, and other dilutive securities).
Adjusted EPS v/s EPS
A base EPS measure can provide an incomplete picture of a company’s financials as it can be influenced by one-time factors like an asset sale, which can deflate or inflate the net income. To counter this, adjusted EPS takes into account the net income of the company after the impact of such non-recurring factors has been removed. The adjusted EPS measure gives a better reading of the company's core profitability and can help predict future returns. In the adjusted EPS method, the net profits are adjusted, and non-core profit and loss are removed from the equation, leaving an adjusted net income amount. In the Indian context, businesses are not mandated to disclose adjusted EPS numbers, but it is highly recommended.
Limitations of earnings per share
While EPS is a pretty significant tool in financial analysis, it does have a few drawbacks, which are outlined below:
Many businesses manipulate EPS values to portray earning excess profits. This is, however, only a short-term measure and tends to negatively impact a company in the long run.
Short-term EPS gains do not always align with the long-term company health.
EPS calculation does not factor in the changes in net income due to inflation. Thus, the change in EPS cannot be completely relied upon to extract accurate insights.
A company’s solvency is an important trust metric among investors as it signals long-term stability. However, EPS does not factor in the cash flow of a business. As a result, despite a high EPS, a company may not have the desired level of solvency.
All these factors reinforce the importance of considering other financial metrics, along with EPS, to accurately assess a company’s financial health.
Conclusion
Earnings per share (EPS) is a key metric indicating a company's profitability per share. Calculated by subtracting preferred dividends from the net profit and dividing that number by the total common shares outstanding, EPS comes in various forms like GAAP EPS, Pro Forma EPS, and Cash EPS, each providing unique insights. While EPS is vital for assessing profitability, comparing companies, and guiding investment decisions, it has limitations, such as potential manipulation and ignoring inflation effects. Thus, EPS should be used alongside other financial metrics to comprehensively analyse a company's financial health.
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