What is Earnings Per Share and Why is it important?

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Earnings Per Share guide

As stock market investors, there are various ratios, concepts, and terms that you need be familiar with. Undoubtedly, Earnings Per Share, or EPS as it’s often referred to, is one of the most important concepts to grasp as an investor. The failure to understand what EPS is or the information that we can derive from EPS will lead to undesirable circumstances in the long-term as a stock market investor.

What is EPS?

As an investor, when you buy a stock, that represents a proportionate ownership of the company issuing the stock. As such, a single share of a company represents a right to a proportionate ownership of that company’s earnings as well. Earnings per share is the amount of company earnings represented by a single stock of a company. For example, if company A has a net income attributable to shareholders of $1,000,000 and common shares of 100,000, the EPS is simply $10, which is calculated as $1,000,000/100,0000.

Why is EPS important?

There are several reasons for EPS to be considered as one of the most important metrics of stock market investment evaluation. First, a negative EPS gives an insight about a company’s inability to earn profits for shareholders, especially if this is persistent. No investor would want to park their money in companies that are failing to earn profits for its investors. While this might not happen immediately, companies with persistent negative earnings often end up destroying value for shareholders in the long-term.

Next, a streak of earnings beats, put simply, EPS figures that beat analyst estimates, will boost the share price of the company. Earnings beats are often considered a very positive sign of the financial performance of the company, and there are instances in which such earnings beats have led to significant price appreciations within the span of a couple of hours.

Earnings per share is a valuable measure to determine a company’s ability to distribute dividends to investors as well. The dividend payout ratio is a popular measure of how safe a company’s dividend is and is calculated based on the EPS.

In addition to this, many important and widely used investor ratios are based on the EPS of a company. For example, the price-to-earnings ratio is calculated using the EPS of a company.

Price-to-earnings ratio = Market price/ EPS

This is one of the most used investor ratios by analysts and investors to evaluate how pricy a stock is in comparison to the underlying earnings of a company.

Finally, a thorough understanding of the different components that contribute to the EPS of a company is essential to develop financial forecasts of the company. This is an integral part in calculating an intrinsic value for a company.

Where can you find EPS related data for U.S. listed companies?

U.S. listed companies are required to present interim financial reports on a quarterly basis, and these financial reports provide EPS data of companies. As such, investors do not need to necessarily know how to calculate EPS, but an understanding of how to do so is essential to derive the meaning behind these numbers.

Below excerpt from Apple’s interim financial statements reflect how companies report EPS figures at the bottom of their income statements.

(Source – AAPL interim financial report)

Diluted earnings per share is the earnings per share if all convertible securities were exercised today. This provides a better idea than basic EPS for investors, and investors should focus on diluted EPS whenever it’s available.

In addition to just the raw numbers for EPS, all U.S. listed companies provide data as to how EPS was calculated in notes to financial statements. This is another area of financial statements that all investors should keenly monitor.

Pitfalls of using EPS as a valuation measure

Even though EPS is certainly a financial measure every investor should know and familiarize themselves with, no investor should base their investment decisions on entirely EPS related data and ratios. EPS is an accounting measure and is prone to accounting manipulations by fraudulent company managements, as was seen with Enron and WorldCom. Prudent investors should focus on cash-based ratios as well as it’s difficult to manipulate cash based financial ratios. Often, there will be a difference between the EPS of a company in a given period and the cash flow per share generated by the same company in the same period.

In addition, an understanding of EPS and the factors driving EPS does not provide an idea about the capital structure of the company. Therefore, investors should check the balance sheet of a company to gauge a measure of the financial health of the company before making any investment decisions. A company can use a high level of debt to inflate current period EPS artificially which is an adverse development.

Conclusion

In conclusion, EPS is one of the most important financial ratios every investor should be familiar with. A thorough understanding of how EPS is calculated, and the different drivers of EPS is important in financial modeling, which is the cornerstone of intrinsic value calculation. However, investors should use EPS in combination with several other financial ratios and measures to assess investment opportunities.