Earnings per share (EPS) tells investors how much of a company's net profit has been allocated to each ordinary share. One of the first performance measures to check when analyzing a company's financial health is its ability to earn profits. Let's see how a company's earnings per share is calculated, what its calculation is for and what impact it has.
What are earnings per share
Earnings per share (EPS) tells investors how much of a company's net profit has been allocated to each ordinary share. It is reflected in the company's income statement and is especially informative for companies that only have common shares in their capital structure.
What are earnings per share for?
One of the first performance measures to check when analyzing a company's financial health is its ability to earn profits. Earnings per share (EPS) are the industry standard that investors rely on to see how well a company has done. Basic earnings per share is an approximate measure of the amount of a company's earnings that can be allocated to one common share. Companies with simple capital structures, in which only ordinary shares have been issued, only need to publish this ratio to reveal their profitability. Basic earnings per share do not take into account the dilutive effects of convertible securities.
Basic EPS = (Net profit – preferred dividends) ÷ weighted average number of ordinary shares outstanding during the period.
What impact do earnings per share have?
Shares trade on multiples of earnings per share, so an increase in core EPS can cause a share price to appreciate in line with the company's increase in earnings per share. The increase in core EPS, however, does not mean that the company is generating higher profits on a gross basis. Companies can buy back shares, thereby decreasing their number of shares and spreading net income less preferred dividends over fewer common shares. Core EPS may increase even though absolute earnings decrease as the number of common shares decreases. Another consideration for basic BPA is its deviation from diluted BPA. If the two EPS measures are increasingly different, it may indicate that there is a high potential for dilution of current common shareholders in the future.
VISA EPS growth forecast from 2021 to 2026. Source: Simplywall.st.
Example of using earnings per share
Let's give an example to see how a company's earnings per share are calculated. Let's say a company declares net income of 100 million dollars after expenses and taxes. The company issues preferred dividends to its preferred shareholders worth $23 million, leaving profits available to common shareholders of $77 million. The company had 100 million common shares outstanding at the beginning of the year and issued 20 million new common shares in the second half of the year. As a result, the weighted average number of common shares outstanding is 110 million:
100 million shares for the first half of the year and 120 million shares for the second half of the year
(100 x 0,5) + (120 x 0,5) = 110. Dividing the earnings available to common shareholders of $77 million by the weighted average number of common shares outstanding of 110 million gives a basic EPS of $0,70.