Earnings, otherwise known as net income or net profit, represents the money that's left over after a company pays all of its bills. For many investors, the growth of a company's earnings is the most important factor when analyzing a company. It's often used as a gauge of profit performance.

Knowing a company's earnings growth is important; however, it is a bit pointless if the growth is generated not by sales but by new share capital issued for cash. Profit can be therefore be determined more accurately through a close examination of changes in earnings per share (EPS) and diluted earnings per share. By taking into consideration the size of a company's increased capital base, changes in EPS provide a far better view of a company's fundamentals and changing fortunes. (Learn more in Everything Investors Need To Know About Earnings.)

EPS Says More
The best way to explain the importance of EPS is with an example. Let's say Tricky Inc. reported year-end earnings of $12 million. It also boasted an outstanding 50% net earnings increase from the previous year's $8 million in earnings. Without question, that would have been an outstanding result had the increase been made using the same amount of capital as in the previous year. But it wasn't.

Over the year, Tricky Inc. acquired numerous businesses that were paid for by issuing new shares to the sellers. Shares on issue, as a result, increased by 25% from 100 million to 150 million. So, while earnings increased by 50%, this was largely due to the profits from the acquired businesses that were funded from the increased share capital. Therefore, Tricky Inc.'s profit improvement was far less than it appears. By examining changes in EPS - which, as we mentioned above, takes into account increases in capital base - we can see the real extent of Tricky Inc.'s "profit" growth. (Learn more in Earnings: Quality Means Everything.)

Calculations Are Not So Simple
All listed companies are required to report EPS in their financial statements. But calculating EPS is not quite as simple as dividing earnings by the number of shares on issue at the balance date. If the number of shares on issue has changed during the year, you need to account for how much of the year they were on issue and calculate the weighted average number of shares on issue during the year.

Let's take another look at Tricky Inc. On Jan 1, 2003, it had 100 million shares on issue. On Mar 31, it issued 50 million additional shares. So, for nine months of the year there were 150 million shares. Therefore, the weighted average number of shares as reported by Tricky should be (100 shares x 1/4 year) + (150 shares x 3/4 year) = 137.5 shares.

Now we can calculate the EPS. For the year, Tricky Inc. earned $12 million per 137.5 million shares, or 8.7 cents per share. That's not much higher than the previous year's EPS of $8 million per 100 million shares, or 8 cents a share.

Now that we've determined its EPS, Tricky Inc.'s performance doesn't look quite so outstanding. Although the company announced that earnings rose by 50%, its earnings per share grew by a less impressive 8.75% ([8.7 -8]/8).

Diluted EPS
Another number that goes a long way towards revealing a company's true state of affairs is diluted earnings per share, which is also measured as net income divided by the average number of shares on issue during the period. But diluted EPS takes into account shares that might be issued in the future as a result of, say, the exercise of options.

Let's say Tricky Inc. had a total of 20 million options on issue with an exercise price of $2.50 and exercise date coming up. Tricky Inc. shares are trading at $3 per share. Because the options are priced at a 50-cent discount, the possibility of dilution is real. So, we should include the impact on EPS. Diluted EPS is calculated as $12 million earnings/170 million shares, or 7.1 cents per share.

Diluted EPS is important because it accounts for the cost to shareholders of options and other securities than can affect the number of outstanding shares. For more on the cost of employees stock options for companies see the feature Accounting and Valuing ESOs.

As they don't adjust for new share issues and takeovers, earnings figures on their own do not tell investors nearly enough about performance fundamentals. An absolute increase in net income is not in itself an adequate indicator because net income may go up as a result of increased investment. More investment will certainly generate additional earnings for the company, but for investors like you and me, the real question is whether growth in earnings compensates for more shares.

Related Articles
  1. Options & Futures

    How To Sell Put Options To Benefit In Any Market

    Selling a put option is a prudent way to generate additional portfolio income and gain exposure to desired stocks while limiting your capital investment.
  2. Options & Futures

    How To Buy Oil Options

    Crude oil options are the most widely traded energy derivative in the New York Mercantile Exchange.
  3. Stock Analysis

    Analyzing Microsoft's Return on Equity (ROE) (MSFT)

    Discover a detailed analysis of Microsoft's historical return on equity, and learn how its ROE stacks up to its competitors in the tech industry.
  4. Retirement

    Roth IRAs Tutorial

    This comprehensive guide goes through what a Roth IRA is and how to set one up, contribute to it and withdraw from it.
  5. Options & Futures

    What Does Quadruple Witching Mean?

    In a financial context, quadruple witching refers to the day on which contracts for stock index futures, index options, and single stock futures expire.
  6. Economics

    Understanding Cost-Volume Profit Analysis

    Business managers use cost-volume profit analysis to gauge the profitability of their company’s products or services.
  7. Fundamental Analysis

    5 Basic Financial Ratios And What They Reveal

    Understanding financial ratios can help investors pick strong stocks and build wealth. Here are five to know.
  8. Options & Futures

    4 Equity Derivatives And How They Work

    Equity derivatives offer retail investors opportunities to benefit from an underlying security without owning the security itself.
  9. Options & Futures

    Five Advantages of Futures Over Options

    Futures have a number of advantages over options such as fixed upfront trading costs, lack of time decay and liquidity.
  10. Investing Basics

    How to Analyze a Company's Inventory

    Discover how to analyze a company's inventory by understanding different types of inventory and doing a quantitative and qualitative assessment of inventory.
  1. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  2. What items are considered liquid assets?

    A liquid asset is cash on hand or an asset that can be readily converted to cash. An asset that can readily be converted ... Read Full Answer >>
  3. What is after-hours trading? Am I able to trade at this time?

    After-hours trading (AHT) refers to the buying and selling of securities on major exchanges outside of specified regular ... Read Full Answer >>
  4. What is the formula for calculating EBITDA?

    When analyzing financial fitness, corporate accountants and investors alike closely examine a company's financial statements ... Read Full Answer >>
  5. How can working capital affect a company's finances?

    Working capital, or total current assets minus total current liabilities, can affect a company's longer-term investment effectiveness ... Read Full Answer >>
  6. What are working capital costs?

    Working capital costs (WCC) refer to the costs of maintaining daily operations at an organization. These costs take into ... Read Full Answer >>
Hot Definitions
  1. Short Selling

    Short selling is the sale of a security that is not owned by the seller, or that the seller has borrowed. Short selling is ...
  2. Harry Potter Stock Index

    A collection of stocks from companies related to the "Harry Potter" series franchise. Created by StockPickr, this index seeks ...
  3. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  4. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  5. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  6. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
Trading Center