Earnings Per Share (EPS)
Earnings per share (EPS) is a financial ratio which computes how much a firm earns in net profits which is attributable to common shareholders. It is calculated by dividing net earnings by the average number of shares outstanding in a given time period.
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Earnings Per Share Formula
The formula is: EPS= Net Income -Preferred Dividends/ Weighted Average number of Shares in issue. (E.g. Net Income £1, shares outstanding 1,000= EPS 1/1000 = 0.01P per share).
This number indicates the earnings power of a company.
It is better used to compare firms operating in the same industry – assuming the same number of shares outstanding, the higher EPS indicates better overall profitability.
Typically, the number is used in tandem with the share price to determine a P/E ratio, (price divided by EPS). The lower the P/E, the cheaper the company’s shares are.
Trading Using EPS
There are caveats to the use of EPS:
- The EPS number referenced above does not take into account the dilutive effect of new shares that could be issued in the future (share options or convertible bonds for example).If these are exercised, it will depress EPS proportionately to the number of new shares created.
- Earnings Per Share figures can be inflated in a variety of ways, either deliberately or not, by other factors including management decisions, which may take the form of “extraordinary” or “exceptional” items, (i.e. one-off events), which ordinarily should be excluded from the Net Income calculation.Similarly, share buybacks have the effect of reducing shares outstanding, thereby inflating the EPS number, as might changes in accounting policies which serve to change the EPS figure, often to flatter the company’s valuation (as a rise in EPS, ceteris paribus, would lower the P/E ratio).
- EPS does not consider cash-flow. If a firm cannot pay its day-to-day bills, the EPS figure will be irrelevant, as the company could go bankrupt.In an inflationary environment, EPS can be inflated simply due to the fact that overall prices are rising, which could lead to problems with buying new inventory at affordable prices in the future. Thus a management focus on EPS may lead to emphasis being unduly placed on short term rather than long term performance.
Earning Per Share is a simple and quick metric to use, for what might be a very complex organisation. It should therefore be treated with caution and not relied upon as the determining factor in making an investment.