What is Earnings Per Share(EPS)?

As a layman, we understand that a company does business to earn profits in the market. We, as investors, invest in a company to be a part of their profitability. For that judgement, Earnings Per Share or EPS is one of the most popular and effective metrics.

As the name suggests, EPS is earnings of a company per unit of shares outstanding. The higher the EPS number, we can say - higher is the company's profitability. Say, Company A earns profits worth Rs. 10 lakhs and has a total of 10,000 shares. If I'm a shareholder of company A, I can say that the company earned Rs. 100 for each share that I bought. Thus, EPS for shareholders of company A is Rs. 100. Let's dive deeper into this concept.

What is EPS?

Earning Per Share is a Profitability Ratio that helps an investor to measure the earning capacity of the firm. This number is reported at the bottom of the income statement and is widely used by investors for the judgement of a company. A higher EPS indicates that the company is profitable and has more profits to distribute to its shareholders. The company can either reinvest these profits into the business or distribute these profits by way of dividends to the shareholders.

Calculation of EPS

EPS = (Net Income - Preferred Dividends) / Common Shares outstanding.

The calculation for EPS is simple; XYZ made a profit of Rs. 800 Cr in the financial year. The total shares outstanding in the market are worth Rs. 4 Cr. So dividing 800/4, the EPS works out to Rs. 200 per share.

Types of EPS

The following table gives an overview about the types of EPS

Basic EPS vs Diluted EPS

Basic EPS is the same as EPS. However, companies having a complex capital structure may have potentially dilutive shares. A company with a complex capital structure uses multiple forms of securities to raise funds rather than relying only on one asset class which is common stock. Some companies issue Preferred Shares, Bonds or Debentures, which can later be converted into Equity shares. 

Diluted EPS takes into consideration the effect of these Convertible securities. It is calculated by dividing the Earnings by the outstanding common stocks as well as convertible securities outstanding. Basically, Diluted EPS assumes that all the potentially dilutive stocks have actually been diluted into common stock. If the above company XYZ has convertible debt worth Rs. 4 cr, the Diluted EPS would be 800/(4+4) = Rs. 100.

Importance of EPS

EPS is the only matrix in fundamental analysis that focuses on net income to find out how much an investor is gaining by investing into that company. A constantly growing EPS means that the profitability of the company is constantly increasing, and the shareholders are getting to be part of that profitability growth.

EPS matters because strong earnings tend to drive the price per share up, and that's good for the investors. The logic is simple. A company that is making higher profits will be preferred by the investors over the companies with lower EPS.

Many investors also like steady income by way of dividends. Although EPS is not a direct representation of dividend payment, investors tend to believe that only companies with a high EPS can afford to pay them dividends. 

Limitations of EPS

Since EPS is such an important number, some companies may also end up manipulating the numbers. This can be done through buying back their own shares or reversing the splitting of stocks. Both of these activities reduce the number of shares outstanding, resulting in higher Earnings Per Share. This drives the EPS up without any actual increase in earnings!

Besides, EPS also fails to take into account the debt of a company. For example:

As you can see, P and Q have the same EPS, but P uses less capital than Q to generate the same amount of profit - indicating that P is much more efficient than Q. Hence, it's important for investors to check the quality of the EPS numbers.

EPS Quality 

A high-quality EPS means that the earnings of the company give a true and fair view of the company's actual performance. It may include a company's earning recognition strategy. These strategies can differ from sector to sector and company to company. EPS can also improve when the company becomes more efficient in reducing its cost, thereby indicating better performance.

Evaluating EPS Quality

Since EPS is a byproduct of a company's earnings, it is important to look at the company's income statement when evaluating the quality of its EPS and earnings. This can help the investor in evaluating the incomes as well as the expenses incurred. Operating profit margin, Gross profit margin and Net profit Margin are all important to evaluate how efficiently the company works out its expenses.

At times using EPS in comparison to that of other companies and other periods can make more sense to the analyst. It's important to look at EPS from different angles. 

Looking at the cash flow statement can help the investor analyse if the cash is being generated through the core operating activities or are some mere investment gains. An increased cash flow without an increase in cash flow from the core business activities can be an issue of concern for the investors. If Mr A is a manufacturer of garments and the majority of his cash flow for the financial year is from the sale of used machines, the cash flows can turn out to be misleading for his stakeholders. 

Conclusion

Despite EPS being a simplistic tool, as a measure of financial soundness, it is extremely powerful. It concentrates really crucial information into a single number. Investors can compare their investments from different sectors industries and with alternative investments to an extent.

A comparison of a company's financial performance over time can also be done using this tool. Be it on a particular day or over a period of time, Earnings Per Share helps investors make informed decisions.

EPS can also be considered one among the most powerful indicators. Looking at the Earnings per share can be a headstart for investors to filter out the non-profitable companies out of their bucket list.

Having said that, EPS, per se, can't be the sole deciding factor while investing. All the attributes in a company are intertwined and must be taken into consideration before making any investment decision.

Invest wisely!