What is Earnings Per Share - EPS
Earnings per share (EPS) is the portion of a company's profit allocated to each share of common stock. Earnings per share serves as an indicator of a company's profitability. It is common for a company to report EPS that are adjusted for extraordinary items, potential share dilution. Most simply EPS is calculated as:
Earnings Per Share Explained
How to Calculate Earnings Per Share - EPS
To calculate the EPS of a company, the balance sheet and income statement are used to find the weighted average number of common shares, dividends paid on preferred stock (if any), and the net income or earnings. It is more accurate to use a weighted average number of common shares over the reporting term, because the number of shares can change over time. Any stock dividends or splits that occur must be reflected in the calculation of the weighted average number of shares outstanding. Some data sources simplify the calculation by using the number of shares outstanding at the end of a period.
The calculation of EPS for three companies at the end of the 2017 fiscal year follows:
Basic vs. Diluted EPS
The formula used in the table above calculates the basic EPS of each of these select companies. Basic EPS does not factor in the dilutive effect of shares that could be issued by the company. When the capital structure of a company includes stock options, warrants, restricted stock units (RSU), etc., these investments, if exercised, could increase the total number of shares outstanding in the market. To better show the effects of additional securities on per share earnings, companies also report the diluted EPS, which assumes that all the shares that could be outstanding have been issued.
For example, the total number of shares that could be created and issued from NVIDIA's convertible instruments for the fiscal year ended in 2017 was 33 million. If this number is added to its total shares outstanding, its diluted weighted average shares outstanding will be 599 million + 33 million = 623 million shares. The company's diluted EPS is, therefore, $3.05B / 623 million = $4.82.
Sometimes an adjustment to the numerator is required when calculating a fully diluted EPS. For example, sometimes a lender will provide a loan that allows them to convert the debt into shares under certain conditions. The shares that would be created by the convertible debt should be included in the denominator of the diluted EPS calculation, but if that happened then the company wouldn’t have paid interest on the debt. In this case the company or analyst will add the interest paid on convertible debt back into the numerator of the EPS calculation so the result isn’t distorted.
Expanding the Basic EPS Formula
Earnings per share can be distorted both intentionally and unintentionally by several factors. Analysts use variations of the basic EPS formula to avoid the most common ways that EPS may be inflated.
Earnings Per Share Without Extraordinary Items
Imagine a company that owns two factories where they make cell phone screens. The land on which one of the factories sits has become very valuable as new developments have surrounded it over the last few years. The company’s management team decides to sell the factory and build another one on less valuable land. This transaction creates a windfall profit for the firm.
While this land sale has created real profits for the company and its shareholders, it is considered an “extraordinary item” because there is no reason to believe the company can repeat that transaction in the future. Shareholders might be misled if the windfall is included in the numerator of the EPS equation, so it is excluded. A similar argument could be made if a company had an unusual loss – maybe the factory burned down – which would have temporarily decreased EPS and should be excluded for the same reason. The calculation for EPS excluding extraordinary items is as follows:
Earnings per share from continuing operations
A company started the year with 500 stores and made $5 EPS. However, assume that this company closed 100 stores over that period and ended the year with 400 stores. An analyst will want to know what the EPS was for just the stores that the company plans to continue with into the next period. In this example, that could increase the EPS because the 100 closed stores were perhaps operating at a loss. By evaluating EPS from continuing operations an analyst is better able to compare prior performance to current performance.
The calculation for EPS from continuing operations follows:
Importance of Earnings Per Share - EPS
Earnings per share (EPS) is one of the most important variables in determining a share's price. It is also a major component used to calculate the price-to-earnings (P/E) valuation ratio, where the 'E' in P/E refers to EPS. By dividing a company's share price by its earnings per share, an investor can see the value of a stock in terms of how much the market is willing to pay for each dollar of earnings.
In the Markets
An important aspect of EPS that's often ignored is the capital that is required to generate the earnings (net income) in the calculation. Two companies could generate the same EPS number, but one could do so with fewer net assets - that company would be more efficient at using its capital to generate income and, all other things being equal, would be a "better" company. A metric that can be used to identify companies that are more efficient is Return on Equity (ROE).
While EPS is widely used as a way to track a company’s performance, shareholders do not have direct access to those profits. A portion of the earnings may be distributed as a dividend, but all or a portion of the EPS will be retained by the company. Shareholders, through their representatives on the board of directors, would have to change the portion of EPS that is distributed through dividends in order to access more of those profits.
Because shareholders can’t access the EPS attributed to their shares, the connection between EPS and a share’s price can be difficult to define. This is particularly true for companies that pay no dividend. For example, it is common for technology companies to disclose in their initial public offering documents that the company does not pay a dividend and has no plans to do so in the future. On the surface, it is difficult to explain why these shares would have any value to shareholders.
The actual notional value of EPS also seems to have a relatively indirect relationship with the share price. For example, the EPS for two stocks could be identical but the share prices may be wildly different. For example in October 2018, Southwestern Energy Company (SWN) earned $1.06 per share in diluted earnings from continuing operations, with a share price of $5.56. However, Mellanox Technologies (MLNX) had $1.02 EPS from continuing operations, with a share price $70.58.
On the surface it seems like SWN is the better deal because an investor is only paying $5.25 per dollar of earnings ($5.56 share price / $1.06 EPS = $5.25). Investors in MLNX are paying $69.20 per dollar of earnings ($70.58 share price / $1.02 EPS = $69.20). This ratio is also known as the earnings multiple or Price/Earnings (PE) ratio.
Although the comparison between MLNX and SWN is extreme, investors will generally find a comparison of EPS and share prices between industry groups to be difficult to compare. Stocks that are expected to grow (e.g. technology, retail, industrial) will have a larger Price to EPS (PE) ratio than those that are not expected to grow (e.g. utilities, consumer staples).
Making a comparison of the PE ratio within an industry group can be helpful, but in unexpected ways. Although it seems like a stock that costs more relative to its EPS when compared to peers might be “overvalued,” the opposite tends to be the rule. Investors are willing to pay more for a stock, regardless of its historical EPS, if it is expected to grow or outperform its peers. In a bull market, it is normal for the stocks with the highest PE ratios in a stock index to outperform the average of the other stocks in the index.
Earnings Per Share (EPS) Summary
Earnings per share is calculated as the net income (AKA profits or earnings) divided by the available shares. A more refined calculation adjusts the numerator and denominator for shares that could be created through options, convertible debt, or warrants. The numerator of the equation is also more relevant if it is adjusted for continuing operations. Comparing EPS in absolute terms may not have much meaning to investors because ordinary shareholders do not have direct access to the earnings. Instead, investors will compare EPS with the share price of the stock to determine the value of earnings and how investors feel about future growth.