What It Measures
The portion of a company’s profit allocated to each outstanding share of a company’s common stock.
Why It Is Important
Earnings per share is simply a fundamental measure of profitability that shows how much profit has been generated on a per-share-of-stock basis. Were the term worded as profit per share, the meaning certainly would be much clearer, if not self-evident.
By itself, EPS doesn’t reveal a great deal. Its true value lies in comparing EPS figures across several quarters, or years, to judge the growth of a company’s earnings on a per-share basis.
How It Works in Practice
Essentially, the figure is calculated after paying taxes and dividends to preferred stockholders and bondholders. Barring extraordinary circumstances, EPS data are reported quarterly, semiannually, and annually.
To calculate EPS, start with net income (earnings) for the period in question, subtract the total value of any preferred stock dividends, then divide the resulting figure by the number of shares outstanding during that period:
Earnings per share = (Net income – Dividends on preferred stock) ÷ Average number of shares outstanding
By itself, this formula is simple enough. Alas, defining the factors used in the formula invariably introduces complexities and—as some allege on occasion—possible subterfuge.
For instance, while companies usually use a weighted average number of shares outstanding over the reporting period, shares outstanding still can be either “primary” or “fully diluted.” Primary EPS is calculated using the number of shares that are currently held by investors in the market and able to be traded. Diluted EPS is the result of a complex calculation that determines how many shares would be outstanding if all exercisable warrants and options were converted into common shares at the end of a quarter. Suppose, for example, that a company has granted a large number of share options to employees. If these options are capable of being exercised in the near future, that could alter significantly the number of shares in issue and, thus, the EPS—even though the E part (the earnings) is the same. Often in such cases, the company might quote the EPS both on the existing shares and on the fully diluted version. Which one a person considers depends on their view of the company and how they wish to use the EPS figure. In addition, companies can report extraordinary EPS, a figure which excludes the financial impact of unusual occurrences, such as discontinued operations or the sale of a business unit.
For example, “pro-forma earnings” tend to exclude more expenses and income used to calculate “reported earnings.” Pro-forma advocates insist that these earnings eliminate all distortions and present “true” earnings that allow pure apples-with-apples comparisons with preceding periods. However, “nonrecurring expenses” seem to occur with such increasing regularity that one may wonder if a company is deliberately trying to manipulate its earnings figures and present them in the best possible light, rather than in the most accurate light.
“Cash” earnings are earnings from operating cash flow—notably, not EBITDA. In turn, cash EPS is usually these earnings divided by diluted shares outstanding. This figure is very reliable because operating cash flow is not subject to as much judgment as net earnings or pro-forma earnings.
Tricks of the Trade
Given the varieties of earnings and shares reported today, investors need to first determine what the respective figures represent before making investment decisions. There are cases of a company announcing a pro-forma EPS that differs significantly from what is reported in its financial statements. Such discrepancies, in turn, can affect how the market values a given stock.
Investors should check to see if a company has issued more shares during a given period, since that action, too, can affect EPS. A similar problem occurs where there have been a number of shares issued during the accounting period being considered. Which number of issued shares do you use, the opening figure, the closing figure, or the mean? In practice the usual method is to use the weighted mean number of shares in issue during the year (weighted, that is, for the amount of time in the year that they were in issue).
“Trailing” earnings per share is the sum of EPS from the last four quarters and is the figure used to compute most price-to-earnings ratios.
Diluted and primary shares outstanding can be the same if a company has no warrants or convertible bonds outstanding, but investors should not assume anything, and need to be sure how “shares outstanding” is being defined.