Earnings per Share (EPS)

Earnings per share (EPS) is a profitability indicator which shows dollars of net income earned by a company in a particular period per share of its common stock (also called ordinary shares). Earnings per share is calculated by dividing net income for a period attributable to common stock owners by the weighted average number of common shares outstanding during the period.

EPS is a very important profitability ratio, particularly for shareholders of a company, because it is a direct measure of dollars earned per share. Accounting standards (such as IAS 33 in IFRS framework and ASC 260 in US GAAP) require companies that have securities that are publically traded or which are in process of issuing publically tradable securities, to report EPS figures on the face of their income statement.

Analysis

In analyzing profitability of different companies, total net income figures alone are not very useful because they are dependent on size of the company. EPS standardizes earnings with reference to number of shares outstanding. However, EPS alone too is not very useful because different companies have different number of shares, some companies opt to have more number of ordinary shares while others prefer to have less. For example, a company may go for a 2-for-1 stock split to double the number of its ordinary shares, without having zero effect on its market capitalization i.e. its value. EPS is used as an input in other very important indicators of profitability and investment performance, such as price-to-earnings (P/E) ratio which compares EPS with price per share of common stock.

EPS is defined as net income attributable to each share of a company’s common stock (or ordinary shares). Common stock or ordinary shares is the class of share capital which represents the right to ultimate ownership of the company. There are other classes of share capital: such as preferred stock, etc., which do not share in the residual interest of the company. Hence, we subtract the claim of preferred stockholders from net income to arrive at the net income attributable to common stock.

Since the number of shares of common stock of a company fluctuate during any particular period because companies continuously issues new shares, go for stock splits, issue stock dividends and buy back shares, etc., per share figure for EPS is calculated based on weighted average number of common shares outstanding.

EPS comes in two flavors: basic EPS and diluted EPS. Diluted EPS is a worst-case EPS which calculates the net income attributable to each share of common stock under the assumption that all such financial instruments of a company which can be converted to common stock are indeed converted.

Formula

EPS is calculated using the following formula:

Earnings per Share (EPS) =Net Income – Preferred dividends
Weighted Average Number of Common Shares Outstanding

Weighted average number of shares is calculated by time-weighted the number of shares of common stock. For example, if Company A has 1,000 shares on 1 January 2015, issues 500 additional shares on 1 July 2015 and does not change its number of shares in the remaining six months of 2015, its weighted average number of shares would be 1,250 [1,000×6/12+1,500×6/12]. 1,000 shares remained outstanding for 6 months, i.e. from 1 January 2015 to 30 June 2015. But for the next six months, i.e. from 1 July 2015 to 31 December 2015, the number of shares increased from 1,0000 to 1,500 so they are also weighted for 6 months. Where a company undergoes a stock split or issues a stock dividend such that its number of shares increases, the change is included in calculation of weighted average number of shares as if it occurred at the beginning of the period.

Example

Today is 15 April 2016. You are a Financial Analyst at JDx, a top-notch investment management firm. Your supervisor has asked you to analyze ABC, Inc. and DEF, Inc. based on their earnings per share (EPS) and P/E ratios.

Both the companies are listed on MDX, the country top securities market. Stock prices of ABC, Inc. and DEF, Inc. as at 31 March 2016 were $40 and $70 respectively. ABC, Inc. financial statements for the year ended 31 March 2016 are available which report an EPS of $2.5 per share for the year ended 31 March 2016. While complete financial statements for DEF, Inc. are not yet available, the company has reported its net income for the year ended 31 March 2016, which is $9.5 million. Following additional public information is available from the company’s investor relations website:

Calculate EPS for DEF and calculate P/E ratios for both companies.

Solution

EPS =Net Income – Preferred dividends
Weighted Average Number of Common Stock

Weighted average number of shares of common stock outstanding during the period equals 2,312,500 as calculated below:

No. of sharesTime (months)WeightWeighted average
2,000,00030.25500,000
2,500,00060.51,250,000
2,250,00030.25562,500
2,312,500

The first slab of shares i.e. 2,000,000 has a weight of 0.25 because the company had this much number of outstanding ordinary shares for 3 months i.e. from 1 April 2015 till 30 June 2015. The second slab of shares remained outstanding for 6 months i.e. from 1 July 2015 till 31 December 2015 hence it has 0.5 weight.

Net income attributable to common stock holders = net income – preferred dividends

Preferred dividends = $10,000,0000 × 8% = $800,000

EPS =9,500,000 – 800,000= $3.76 per share
2,312,500

Price-to-earnings (P/E) ratios are calculated as follows:

ABC P/E ratio = $40/$2.5 = 16

DEF P/E ratio = $70/$3.76 = 18.6

Written by Irfanullah Jan