In order to become a successful investor, it’s important to thoroughly familiarize yourself with a few investing basics. One of the basics is called EPS or earnings per share. In this article, we are going to discuss and look a little closer at how to calculate it, what does it mean and the benefits and the drawbacks of using earnings per share to guide your investment decisions.
What are Earnings per Share?
Earnings per share also known as EPS is a company’s net income divided by the number of shares the company has outstanding. It is used very widely and is one of the most important measurements of a company’s profitability. EPS is typically reported each quarter when the company releases its earnings report.
If the company is profitable for the quarter, its EPS will be positive. If the company loses money over a given quarter, it will report a negative EPS. The quarterly estimates of EPS are very important for the short-term movement of the company’s stock. So we really want to keep track of what’s going on with EPS
How to calculate earnings per share?
EPS can be calculated using the following simple equation:
EPS= net income/ average outstanding shares.
The number of outstanding shares a company has is going to vary due to several reasons. The companies may buy back their stock, sell equity to enhance their liquidity position or even have stock options, etc. A more accurate measurement of EPS is obtained by averaging the number of shares over a given time. However, if you want to be simple about it, you can use the current outstanding shares and still get a pretty accurate measurement. For example, if a company has a net income of $200 million and has an average of 10 million shares, the EPS of the company will be about $20.
What is the significance of EPS?
EPS shows how much money a company is making for its shareholders on a per-share basis but it is more important to look at the company’s EPS over time as it gives us an idea of how fast the company is growing. Ideally, you want to invest in a company that’s been steadily increasing its EPS from quarter to quarter.
So, looking at EPS gives you are more accurate evaluation of a company’s performance than just looking at their earnings alone. Although, you definitely want to look at both of these things as if you look at just earnings by themselves, you are looking at the company through the lens of a single owner like a Warren Buffett or a Charlie Munger who owns the whole company. But we are not a single owner; we own shares of the company so when we look at the EPS or earnings per share we get an idea of how the company is doing for us on each individual share.
Also, it is really important to understand if a company is buying back its own stock or diluting your interest over time. You wouldn’t necessarily see that if you are looking at it just from the point of view of actual earnings. You will see it however when you start dividing those earnings by the number of shares that are outstanding.
The more shares a company buys back, the higher the EPS goes which is good for investors. The more shares the company spends in diluting, the lower the earnings per share go, and meanwhile the company has the same exact earnings overall. So, it is very important to understand earnings per share.
What are the drawbacks of EPS?
EPS can sometimes be deceptive or kind of devious as managers can play around with earnings per share in a way that makes them look quite good even maybe when there are some problems.
For example, EPS is calculated using a method called accrual accounting. In this method, you calculate profits when the money hasn’t even been paid yet, but you have just made the sale. On the other hand, expenses that haven’t been paid but are written off as having been paid.
One of the bad ways is to go out and buy back stock by paying a price for the company’s shares that is far above the value of the company. That is really a horrendous use of an investor’s money. But it really benefits the managers because they can drive the stock price up by increasing the earnings per share. So it can be a little bit devious but we need to know that people are using earnings per share in lots of ways.
So, this makes EPS a little more difficult to use as a great gauge of a company’s performance. We wouldn’t want to use it all by itself because there are companies that are going to report positive earnings per share even though they are losing money and about to go bankrupt.