One of the most important financial ratios that shareholders analyze to evaluate the profitability of a company is earnings per share (EPS). A company's EPS is important because it reports the company's earnings on a per-share basis, which indicates the earning power and relative value of each share of stock outstanding. However, it's only useful if you understand the components of the formula and how to calculate it.
Calculating EPS is straightforward and only requires basic subtraction and division skills. The numerator of the formula equals the net income the company reports on its income statement minus the dividends the company has pledged to shareholders. The denominator of the fraction is equal to the weighted average of the number of outstanding shares of stock during the same accounting period that the net income covers in the numerator.
Calculating EPS Denominator
Using the weighted average for the number of shares a company has outstanding in the denominator of the EPS formula is only necessary if there are fluctuations in the amount of stock a company issues during a single accounting period, which is usually a fiscal year. However, it becomes more important when there are stock splits or the company issues more shares to raise additional capital. For example, if ABC Inc. issues 1,000 shares of stock in an initial public offering on January 1, 2011, and decides to implement a 2-for-1 stock split on July 1, 2011, calculating the weighted average is essential because the number of outstanding shares doubles during the fiscal year and can dilute EPS.
EPS Formula Example
To really understand the EPS formula, you need to see how it calculates with actual numbers. Assume that on January 1, 2011, ABC Inc. has an initial public offering of 1,000 shares of common stock and 100 shares of preferred stock that pay annual dividends of $100 per share. Further assume that the number of outstanding shares of common stock doesn't fluctuate and on December 31, 2011, ABC reports net income of $100,000. To calculate the numerator, subtract the $10,000 dividend that ABC will pay to preferred shareholders from net income, which results in $90,000. Because the number of outstanding shares doesn't change, the denominator is equal to 1,000. Divide $90,000 by 1,000 shares to arrive at EPS of $90.
Significance of EPS
Analyzing the $90 EPS initially tells investors and creditors that the company is doing a good job of generating profit. It also indicates to shareholders whether or not company management is utilizing investor funds efficiently and for profitable ventures. However, it's never a good idea to evaluate a company solely on its EPS. Unless you have data on the company's net income and outstanding shares, the EPS can be misleading. For example, EPS of $90 for a company with 1,000 shares outstanding is not nearly as impressive as a company that reports the same EPS, but with 10 million shares outstanding.