One of the major challenges of investing is deciding whether a company’s stock is worth a spot in your portfolio. If you don’t have some way to measure the stock’s value, you couldn’t know if the current price is a bargain, expensive, or just about right.
Evaluating a stock requires a careful understanding of the company’s earnings: The amount of profit a company made in a given period of time. As such, earnings per share is a key metric investors and analysts use to study a company’s performance.
What is earnings per share?
Earnings per share (EPS) is a calculation of the amount of profit a company generated for each outstanding share of its common stock. Outstanding shares include all shares of a corporation or financial asset that have been authorized, issued, and purchased by investors. These shares represent ownership in the company.
High earnings per share represent the company’s ability to invest in the business or distribute dividends. Investors benefit in either case, so rising earnings per share tends to cause the stock price to rise. Inversely, falling earnings per share can erode the stock price.
Diluted earnings per share
Earnings per share only considers common stock. This represents equity ownership in the company. It gives you the right to vote on management issues. Common stock is what most people mean when they just say “stocks.”
But if a company increases the amount of common stock, the earnings per share will fall. Think of it like sharing a pizza that has eight slices. A party of four can split the pizza so everyone gets two slices. But a party of eight can only distribute one slice per person. By increasing the number of people (the stock), the amount of profit (the pizza) falls for each person.
How does the amount of common stock increase? In some cases, companies simply issue more stock to raise capital. In other cases, they convert different kinds of securities into common stock. They can convert preferred stock (a different kind of stock that receives dividends and doesn’t include voting rights), options, and warrants outstanding. So when a company issues stock or converts other securities into stock, the pool of common stock increases, thus diluting the earnings per share.
As such, a company’s diluted earnings per share is always lower than its basic earnings per share. It’s important to know the company’s diluted earnings per share because this is the bottom number - what your stock could be worth in a worst-case scenario.
Limitations of earnings per share
Earnings per share is a useful way to evaluate a company’s financial health and determine if you want to invest, but it’s not a perfect metric.
Outstanding stock is one of the variables you need to calculate earnings per share. Companies can raise their earnings per share by simply buying back their own shares, thus reducing the amount of outstanding stock. They need not increase their revenue at all. Some companies manipulate investors into thinking the company is growing more than it actually is by doing this.
Additionally, earnings per share doesn’t take into account the company’s outstanding debt or how much capital it needs to generate its earnings. This means two companies may have the same earnings per share even though one carries substantial debt and needs a lot of capital to make money. The company without debt and better margins would be objectively healthier, but the earnings per share wouldn’t show that.
Earnings per share formula
The formula to calculate earnings per share is simple:
Earnings per share = (net income - preferred dividends) / outstanding shares
How to calculate earnings per share
To calculate earnings per share, you’ll need three pieces of data:
- Net income, which is found on the company’s income statement.
- Preferred stock dividends, which is also found on the company’s income statement.
- The number of outstanding shares, which is found on the stockholders’ equity section of the balance sheet.
Once you have this information, there are just two steps to calculating a companies earnings per share:
Step 1: Find the difference between the company’s net income and dividends it paid for preferred stock. This will tell you the total earnings available to shareholders.
Net income - preferred dividends = total earnings
Step 2: Divide total earnings by the number of outstanding shares. This will tell you the company’s earnings per share.
Total earnings / outstanding shares = earnings per share
Earnings per share example
Let’s say ABC Ltd. had a net income of $25 million and paid $2 million to preferred shareholders as dividends. It has 15 million outstanding shares. This means its total earnings came to $23 million.
$25 million - $2 million = $23 million in total earnings
Now let’s find its earnings per share:
$23 million / 15 million shares = $1.53 per share.
Why calculate earnings per share?
Calculating earnings per share is important for investors because it explains the company’s profits on a per-share basis. This makes it simple to compare the company’s performance against previous quarters or years.
Does a higher EPS indicate healthier profit for investors? Not always. Since a company can change the number of outstanding shares (substantially, in some cases), earnings per share can fall even when revenue rises.
For instance, let’s say our example company - ABC Ltd. - had a total earnings of $23 million in 2015 and $35 million in 2018, but they increased their outstanding shares from 15 million to 40 million in the same period. In this case, earnings per share fell from $1.53/share to $0.88/share even though profit grew.
Furthermore, earnings per share is a critical metric used to determine the overall value of a company. It’s part of the price-to-earnings ratio (P/E), which is arguably the most popular way to compare one company to another. By dividing the current share price by the earnings per share, you can evaluate whether a company is cheap, fairly valued, or expensive in relation to other companies in the same sector.
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What’s a good earning per share?
There’s no objectively “good” earnings per share value. EPS is a relative metric that’s best used to appreciate the difference over time. Investors and business leaders want to raise earnings per share as much as possible. (In fact, business leaders have a fiduciary duty to do so.)
Better questions might be…
- How has earnings per share changed?
- Why did the earnings per share change?
To answer the first question, we simply calculate earnings per share at two periods using the formula above. Generally speaking, rising EPS is a positive sign and falling EPS is a negative sign.
To answer the second question, we have to analyze a few variables. These factors will give you a better picture of the company’s health.
It’s important to understand what causes a company’s earnings per share to change over time. While an EPS that rises consistently indicates healthy growth and an EPS that falls might be cause for alarm, neither is solely indicative of anything.
For instance, a local natural disaster might increase the cost of materials and push earnings per share downward for a while, but earnings will improve once material prices stabilize. While past performance is never indicative of future performance, a clear rising or falling EPS trend is a good reason to look for the deeper cause.
Companies in the same sector face similar macro and microeconomics challenges (demographics, politics, economic policies, etc), so we can compare them against the industry average. For instance, if ABC Ltd. has an earnings per share of $14.50 in an industry where the average EPS is $8.30, we know that it’s performing better than most of the industry.
It’s also important to consider whether a company met the market’s expectations for its growth and to what degree. Third-party analysts who follow the company will make predictions about the company’s performance. In many cases, the company itself will publish a forecast. It’s considered a positive sign if a company beats expectations. But it fails to hit those milestones, investors may grow leery about the company’s ability to perform well in the future.
Since earnings per share is an internal number, it isn’t a reliable way to determine if a company’s stock is a good buy. We have to consider the EPS in relation to the company’s market price using the P/E ratio.
As we said, you can find the P/E ratio by dividing the share price by earnings per share. If a company sells shares for $75 and has an earnings per share of $2.50, its P/E ratio would be $30 ($75 divided by $2.50). Generally speaking, companies with higher P/E ratios are healthier companies and better buys.
Several internal variables may also affect a company’s earnings per share. Share buybacks or splits, restructuring, mergers and acquisitions, and accounting policies can affect profit, preferred stock dividends, and the amount of outstanding stock (the three variables that influence earnings per share).
For example, a company might lay off workers to reduce labour expenses, but that’s not something it can do every quarter to keep its EPS rising. Make sure you investigate what’s going on inside a company before you decide if their earnings per share trend is positive or negative.
All in all, earnings per share is an important metric to evaluate a company’s growth and compare it against similar companies. Use it to inform your stock buying decisions.
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