Earnings Per Share (EPS) Ratio: Complete Guide

Calculation Formula & Example | Definition & Explanation | What is "Good" | Top Tips

Emilie N.- FCCA, CB, MBS
Emilie N.- FCCA, CB, MBS

Emilie is a Certified Accountant and Banker with Master's in Business and 15 years of experience in finance and accounting from corporates, financial services firms - and fast growing start-ups.

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Contents

Definition: What is Earnings Per Share (EPS)?

In other words, if a company paid out all of its profits to shareholders, EPS is the portion of the net income that would be allocated to each share.

Interpretation: What is a “Good” EPS?

The higher a company’s EPS, the more attractive its shares are considered to be, and stock with earnings-per-share steadily increasing over time is regarded as a more reliable investment than one with a fluctuating or declining ratio.

However, there is no ideal EPS figure or threshold.

Instead, the past performance and future prospects of a company and its stock are evaluated by comparing the EPS growth against:

  • Previous accounting periods (e.g., quarter or year)
  • Similar companies (e.g., industry benchmarks)
  • Other forms of investment
  • Company’s share price

Benefits: Why Is EPS Important?

Investors buy shares in a company for two main reasons:

  • Dividends: Receive dividend payments
  • Capital gains: Sell the stock at a higher price as its market value increases in the future to make a profit

The earnings of a company drive both its dividend payments and the market value of stocks, because it has more money available to distribute through dividends or reinvest into the business.

Moreover, the EPS is used to calculate other important ratios that assess the return on investment into the ordinary shares of a company, including the Price/Earnings (P/E) ratio, Earnings Yield and Dividend Cover.

In fact, since the EPS figure is used to calculate the P/E ratio, a major stock market indicator of performance, it can have a significant effect on a company’s share price:

That’s why EPS is a key investor ratio that enables existing and prospective shareholders to:

  • Assess past performance of a company and its stock
  • Estimate future earnings and increases in market value
  • Evaluate market value of stocks relative to earnings

However, the EPS has many shortcomings and limitations that can lead to misleading results and prevent you from using the ratio effectively.

That’s why you should be 100% clear on how to calculate, interpret and use EPS to your best advantage >>>

Formula: How Is EPS Calculated?

EPS Calculation: Basic Earnings-per-Share

The formula for calculating EPS is:

Earnings Per Share (EPS) = Earnings ÷ Shares

As you can see, calculating basic Earnings Per Share is easy:

If a company with 1,000 shares earns $10,000, its EPS is simply $10 (= $10,000 ÷ 1,000).

However, although the ratio is simple in principle, many complications may arise in practice due to the different definitions and accounting treatments of both the earnings and shares:

Earnings

In the EPS formula, the numerator refers to Net Profit (also known as Net Income or Net Earnings) distributable to ordinary (aka common) equity shareholders, which means earnings for the period:

  • Less interest and tax
  • Less preference share dividends paid in the period (EPS represents only the earnings available to common shareholders and preferred stock dividends take precedence before common shareholders are entitled to anything.)
  • Less profit from non-core extraordinary items and discontinued operations (exclude any unusual items that would temporarily distort the EPS to ensure it represents only earnings generated from core operations on a normalized basis)
  • Less profit attributable to any non-controlling investment or minority interest (applies to consolidated financial statements where EPS is based on the consolidated profit attributable to the shareholders of the parent company)

Note that the earnings could amount to a loss (as opposed to a profit) attributable to ordinary shareholders.

Shares

In the EPS formula, the denominator refers to the number of ordinary (aka common) equity shares outstanding during all or part of the period.

  • At its most simple form, the EPS calculation uses the number of shares outstanding at the end of a reporting period.
    • However, if the number of outstanding shares changes throughout the period, it is more accurate to calculate an average or weighted average instead of just using the end-of-period figure.
  • The calculation generally uses the number of shares outstanding (i.e., excluding treasury stock held by the public company itself) as opposed to the total number of all shares in issue.

Since EPS is the monetary value of earnings per outstanding share of common stock, it is expressed as cents per share to 1 decimal place.

Companies usually report their EPS on a quarterly or annual basis.

EPS Calculation: Complex Capital Structures

In addition to calculating the basic EPS as per above, you many need to know how to deal with more complex situations, including:

  • Bonus issue
  • Rights issue
  • Share splits
  • Diluted EPS (DEPS) – conservative “worst case” scenario calculation that includes any dilutive securities (e.g., convertibles, options, warrants), which would increase the number of shares outstanding in the market–and reduce EPS–if exercised and converted to stock.
  • EPS calculated separately for each major category of the income statement (e.g., net income, continuing operations, discontinued operations, extraordinary items)

For that purpose, you need to consult the relevant financial reporting standards applicable in your country, such as the IFRS – IAS 33 or US GAAP – SFAS 128, to ensure that the calculation and accounting treatment is in compliance with the local requirements.

EPS Calculation: Past vs. Future

The EPS can be calculated based on historical data (Trailing EPS), future projections (Forward EPS), or both (Current EPS).

EPS Types Trailing Forward Current
Calculation Previous 4 quarters. Future 4 quarters. Current fiscal year, some of the 4 quarters may have passed.
Actuals Yes No Yes
Projections No Yes Yes
Pros Represents what actually happened, not what may happen in the future. Investors look for indication of future earning potential. Combination of actuals and projections.
Cons “Old news” Estimates, not reality. Inconsistent and confusing.

Most often, the EPS and P/E ratios are calculated using the trailing basis because it shows what actually happened in the past.

However, investors often use the other two calculations (forward and current) for comparison purposes.

For example, if the current actuals significantly lag behind the forward projections, the stock price may fall–and vice versa.

Example: Calculate EPS Step-by-Step

Earnings Per Share Example:

In the last quarter, Company XYZ generated a net income of $2 million and paid out a dividend of $500,000 to preferred shareholders. Its outstanding common shares stood at 12 million at the beginning of the quarter but the number fell to 10 million at the end of the period.

Here is how we calculate basic earnings-per-share for Company XYZ for the last quarter in 3 simple steps:

Company XYZ - Financials
Net Income: $2,000,000
Preferred Dividend: $350,000
Shares Outstanding - Opening: 12,000,000
Shares Outstanding - Closing: 10,000,000

Step 1: Calculate the net income available to ordinary shareholders:

Net income available to ordinary shareholders =

= ( $2,000,000 – $350,000 ) =

= $1,650,000

Step 2: Calculate the average number of shares outstanding:

Average number of outstanding shares =

= ( 12,000,000 +  10,000,000 ) ÷ 2 =

= 11,000,000

Step 3: Calculate Earnings per Share:

EPS = $1,650,000 ÷ 11,000,000 = $0.15

The EPS of Company XYZ for last quarter was 15c.

Pros & Cons of EPS

Pros: Advantages of EPS

The EPS ratio is widely used as a performance measure between companies and sectors, as well as time periods within the same entity, thanks to its many advantages, including:

  • Straightforward to understand
  • Simple and fast to calculate
  • Convenient as input figures are readily available in the financial statements
  • Calculation is usually clearly defined by accounting standards

Cons: Limitations of EPS

When its earnings-per-share increase, it is an indication that a company is doing well financially and may present a good opportunity for investment.

However, as an overall measure of a company’s financial health, the EPS ratio has many shortcomings.

In fact, the widespread use of the EPS and P/E ratios in the investment community may be largely attributed to their ease of use, because the EPS otherwise has a number of limitations.

Top 9 EPS Limitations:

1. Trend

The EPS ratio on its own is arbitrary. Instead, it is best evaluated through trend analysis, by studying the growth rate of a company over time:

  • Is its EPS growing or declining over time?
  • What is the rate of growth/decline?
  • Is the rate of growth increasing or decreasing?
2. Comparability

For the EPS ratio to be comparable between accounting periods of one company and among different companies, it must be calculated on a consistent basis.

However, EPS may get easily distorted, for example by:

  • Differences in accounting policy
  • Changes in share capital throughout the course of a year
  • Mergers and acquisitions (M&A)
3. Manipulation

The EPS ratio is relatively easy to manipulate.

For instance, companies where EPS is used to determine management bonuses may be particularly motivated to influence the ratio through a share buy-back and consolidation, M&A projects, and changes in treatment of accounting items.

Let’s say that a company buys back its own shares in the open market. This move would improve the company’s EPS without actually increasing its net income, just because the net income now gets divided up by a fewer number of shares outstanding.

As a result, investors could be ‘tricked’ into thinking that the company is doing better than it actually is.

4. Shareholder Value

The correlation between EPS growth and shareholder value is unclear because the calculation is not directly linked to the objective of maximising shareholder wealth.

Firstly, earnings-per-share do not represent the actual income of ordinary shareholders because they do not have direct access to the earnings calculated by the ratio.

While there is a link between EPS and shareholder wealth, they are not the same thing.

Although a portion of a company’s earnings may be distributed as a dividend, the remainder of the EPS can be retained in the company. And some companies pay no dividends at all.

Secondly, high profit may be achieved at the expense of reinvestment back into the business to fuel future growth and sustainable value for shareholders.

When a company passes profits on to its stockholders via dividends or a share buyback, it results in a short-term gain for the shareholders. This needs to be balanced with the alternative of retaining the earnings in the company to increase shareholder returns in the long-term.

Thirdly, the Earnings Per Share are not necessarily directly related to the market value of a company and its stock.

For example, the EPS for two stocks with widely different share prices could be identical.

5. Inflation

Since EPS does not take account of inflation, any increase in earnings likely does not reflect the true growth.

6. Profitability

EPS is essentially a measure of profitability from shareholders’ perspective. However, profitability is only one aspect of company performance. As a result, focusing too much on the bottom line of a company is incomplete, narrow-focused and short-sighted.

There is a wealth of other financial and non-financial factors that come into play when it comes to the success of a company and an investment strategy.

7. Shares

By definition, the EPS is dependant on the number of shares in issue. This needs to be taken into account when comparing the earnings of companies against each other.

As an example, while both of these companies have EPS of 10 cents, the earnings of Company B are drastically lower:

EPS Example Company A Company B
Earnings $10,000,000 $25,000
Shares 10,000,000 250,000
EPS $10,000,000 ÷ 100,000,000 = 10c 25,000 ÷ 250,000 = 10c

Clearly, it is meaningless to compare EPS of one company with another without first calculating the EPS growth rates.

8. Debt

Moreover, the EPS calculation does not factor in the outstanding debt of a company.

9. Capital

EPS does not consider the resources needed to generate the income of a company.

Suppose that Company A and Company B report an identical EPS ratio. However, Company A needs significantly fewer net assets to achieve the same level of earnings as Company B because it is more efficient at utilizing its capital to generate revenue.

Nevertheless, the efficiency of Company A would not be directly reflected in its EPS.

Analysis: Top 5 Tips to Analyze EPS

While the EPS is an important and widely used tool for investors, a single absolute value for one company is arbitrary and using the ratio in isolation does not tell the whole story of a company’s financial strength.

Therefore, for the earnings-per-share analysis to be truly meaningful, the ratio must be evaluated in context and with the awareness of its limitations. Here are the 5 top tips on how to do just that:

1. Track EPS over a period of time

In order to assess a company’s real earning capability and spot trends, investors should compute the company’s EPS for more than one accounting period, and ideally over several years.

Look for trends in EPS growth to get a sense of how profitable a company has been to date and to estimate its future prospects.

  • The higher the EPS, the more profitable a company is considered to be.
  • A company with a steadily increasing ratio is regarded to be a more reliable investment than one with significantly fluctuating or even declining earnings-per-share.

2. Benchmark EPS against similar companies

Compare the EPS to similar companies within the same industry, industry averages or other relevant benchmarks to determine how a company is performing relative to its peers.

For example, between two companies in the same industry with the same number of shares outstanding, and other things being equal, higher EPS indicates higher profitability.

3. Use EPS in conjunction with other metrics

Furthermore, investors should use the EPS figure in conjunction with other ratios and metrics to estimate the future growth, earnings, and stock value of a company.

4. Compare EPS to share price

As part of the P/E ratio, the EPS is used to assess the value of a company’s share price relative to its earnings and determine whether the stock is relatively expensive/over-valued (high P/E ratio) or cheap/undervalued (low P/E ratio).

5. Evaluate financial and non-financial factors

Always analyse both the financial as well as non-financial elements to gain a holistic view of a company.

EPS vs. DPS: Do You Get Paid EPS?

EPS is not paid out to shareholders. Earnings per Share (EPS) is a ratio of a company’s net income per each outstanding share, indicating its profitability. Dividend per Share (DPS) is the ratio that calculates the portion of EPS that is actually shared with stockholders through dividends.

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Emilie N., FCCA, CB, MBS
Emilie N., FCCA, CB, MBS

Emilie is a Certified Accountant and Banker with Master's in Business and 15 years of experience in finance and accounting from large corporates and banks, as well as fast-growing start-ups.

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