One of the primary valuation metrics used by investors to assess a business' worth and financial stability is earnings per share (EPS). EPS reflects a company's net income divided by the number of common shares outstanding. EPS, of course, largely depends on a company's earnings. For EPS calculation, earnings before interest and taxes (EBIT) is used because it reflects the amount of profit that remains after accounting for those expenses necessary to keep the business going. EBIT is also often referred to as operating income.
The relationship between EBIT and EPS is as follows:
EPS = (EBIT - Debt Interest) x (1 - Tax Rate) - Preferred Share Dividends ÷ Number of Common Shares Outstanding
When assessing the relative effectiveness of leverage versus equity financing, companies look for the level of EBIT where EPS remains unaffected, called the EBIT-EPS break-even point. This calculation determines how much additional revenue would need to be generated in order to maintain a constant EPS under different financing plans.
To calculate the EBIT-EPS break-even point, rearrange the EPS formula:
EBIT = (EPS x Number of Common Shares Outstanding) + Preferred Share Dividends ÷ (1 - Tax Rate) + Debt Interest
For example, assume a company generates $150,000 in earnings and is financed entirely by equity capital in the form of 10,000 common shares. The corporate tax rate is 30%. The company's EPS is ($150,0000 - 0) x (1 - 0.3) + 0 / 10,000, or $10.50. Now assume the company takes out a loan of $10,000 with a 5% interest rate and sells an additional 10,000 shares. To calculate the level of EBIT where EPS remains stable, simply input the debt interest, current EPS and updated shares outstanding values and solve for EBIT: ($10.50 x 20,000) + 0 ÷ (1 - 0.3) + $500 = $300,500.
Under this financing plan, the company must more than double its earnings to maintain a stable EPS.