Earnings per share (EPS)

Before reading this lesson, you should have previously read through...

Earnings per share is widely considered the best measure of a share's true price because it shows you how much of a company's profit after tax that each shareholder owns.

Earnings per share is widely considered to be the best measure of a share's true price because it shows you how much of a company's profit after tax that each shareholder owns.

A company's earnings per share (EPS) is calculated by subtracting its dividends on preferred stock from its net income and then dividing this figure by its average number of outstanding shares over a year or a quarter:

Earnings per share = (Net income - dividends on preferred stock) / average outstanding shares

For example, a company that had £20 million in full-year net income, paid out £1 million in preferred dividends and had 10 million shares outstanding in the first half of the year and 15 million outstanding in the second half would have an EPS of £1.52 (£20 million - £1 million, divided by the average 12.5 million shares) for that year.

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Basic EPS and diluted EPS

There is no rule-of-thumb figure that is considered a good or bad EPS, although obviously the higher the figure the better.

It comes in two forms: basic EPS and diluted EPS. Diluted EPS is the same as basic EPS but also includes in the outstanding shares number any shares of convertibles or warrants. Diluted EPS is generally considered a more accurate measure and is more commonly used.

There is no rule-of-thumb figure that is considered a good or bad EPS, although obviously the higher the figure the better.

Compare companies in the same industry

Instead, investors tend to use it to compare companies in the same sector and then look for trends in an individual company's performance.

If auto maker A, for example, has an EPS of £5 and rival auto maker B has an EPS of £4, company A could be the better investment in terms of future share price growth.

Companies can manipulate their earnings via clever accounting and other methods. So be cautious when you apply valuation ratios that involve earnings.

If however, company A has an EPS of £5 but its EPS was £6 last year, while company B has an EPS of £4 but its EPS was £3 last year, company B might now be considered the best investment in terms of future share price growth. This is because its EPS is actually growing so investors might expect an even higher figure next year.

Bear in mind, however, that EPS is not a perfect measure on its own. If you encounter two companies that have the same EPS, factor in how much capital each requires to generate the net income used in the calculation.

The company that uses less capital to generate each £1 of income could be seen as more efficient and a better long-term investment than the company that requires more capital per £1 of income.

Also, be aware that a company's earnings can be subject to manipulation and changes to accounting methods. You should therefore treat a company's EPS figure with the same caution as you would its overall profit.

Summary

So far you have learned that...

  • ... earnings per share is widely considered to be the best measure of a share's true price because it shows you how much of a company's profit after tax that each shareholder owns.
  • ... diluted EPS is the same as basic EPS but also includes in the outstanding shares number any shares of convertibles or warrants.
  • ... diluted EPS is generally considered a more accurate measure and is more commonly used.
  • ... there is no rule-of-thumb figure that is considered a good or bad EPS, although obviously the higher the figure the better.
  • ... investors tend to use it to compare companies in the same sector and to look for trends in an individual company's performance.
  • ... EPS is not a perfect measure on its own. If you encounter two companies that have the same EPS, factor in how much capital each requires to generate the net income used in the calculation.
  • ... company's earnings can be subject to manipulation and changes to accounting methods. You should therefore treat a company's EPS figure with the same caution as you would its overall profit.

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