Earnings per share (EPS) is a measure that calculates how much of a business’ net income can be attributed to each of its outstanding shares. It is a highly useful metric for shareholders, as it allows them to estimate how much they earned for each of the shares they hold.
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A business net income is the calculation of how much it earned from its sales after all costs, expenses, financial charges, depreciation, amortization and taxes are deducted.
The Earnings per Share (EPS) metric is one of the most widely tracked measure in the financial world. It is employed by analysts, investors and managers to understand how much a company earns for each of the business’ outstanding shares and it can be employed as the input of several other metrics such as the Return on Investment (ROI) metric or the Price-to-Earnings (P/E) metric.
The metric can be presented as non-diluted or diluted EPS. The non-diluted EPS indicates how much a business has earned per each of its current outstanding shares, while the diluted EPS shows how much a business has earned per each share currently outstanding plus any potential new share that will be issued if the company’s convertible issues, warrants or stock options are exercised.
The formula to calculate Earnings per Share is the following:
EPS (non-diluted) = Net Income / Current Shares Outstanding
EPS (diluted) = Net Income / Current Shares Outstanding + Exercisable Rights on New Shares
EPS Equation Components
Net Income: The amount of money remaining after all costs, expenses, interest charges and taxes are deducted from the business’ revenues.
Current Shares Outstanding: The total number of shares currently in circulation.
Exercisable Rights on New Shares: The total number of new shares that will be incorporated if any convertible issue, warrant or stock option is exercised.
Cleaning Mate LLC is a publicly traded company that produces cleaning products for households. It specializes in cleaning fluids and powders employed to clean kitchens, bathrooms, floors and many different surfaces. The company has been in business for 10 years and it has reached a mature stage in its life cycle.
It currently sells around $124 million per year and last year’s Net Income was $23 million. It also has 5.6 million shares currently in circulation and the company issued a convertible bond that, if exercised, will create an additional 300,000 new shares.
The year before last year, the business made $18.9 million in net income and had the same number of outstanding shares.
The business Earnings per Share can be calculated as follows:
EPS (non-diluted) for last year = $23,000,000 / 5,600,000 = $4.10
EPS (diluted) for last year = $23,000,000 / 5,900,000 = $3.90
And for the year before that:
EPS (non-diluted) for last year = $18,900,000 / 5,600,000 = $3.38
EPS (diluted) for last year = $18,900,000 / 5,900,000 = $3.20
Analyzing the EPS for the two years, in one year, the company increased both its EPS’s by 21%, which means the business is growing at a significantly fast pace.
The importance of the EPS metric relies on the fact that it standardizes how much a company produces for each of its shares. This allows investors and analysts to estimate several other ratios such as the Price-to-Earnings ratio and the Return on Investment (ROI) ratio, in order to compare businesses of similar size, industry and nature, to assess the performance of their current investment or to choose the one that exceeds the average performance.
Understanding the effect of the dilution of shares is also important to analyze the impact that exercisable rights have on the current EPS situation. If a business creates an incentive for its management team that consists in granting top executives stock options, this will sooner or later have an effect on the current ownership structure and therefore in the distribution of the business’ earnings. This effect is known as dilution, and it reduces the EPS, which directly affects shareholders.
This is the reason why compensation packages based on stock options must be carefully designed, in order to adequately align the interest of the management team with the interest of the shareholders, which is to maximize the value of the company’s shares.
A horizontal analysis of the EPS can be done, as shown in the example above, by comparing the results of the EPS at different periods. It can be done annually, quarterly or even monthly. For seasonal businesses, a quarterly comparison may be the most adequate.
Additionally, the Price-to-Earnings indicator estimate how much the market is currently willing to pay for the business’ shares. A P/E of 20 indicates that the market is willing to pay 20 times the current EPS, which indicates that the business is seen as an attractive investment opportunity. Opposite to that, a business with a P/E of 5 indicates that the market is only willing to invest in the business if the return on their investment occurs within a short period of time.
Similar to the EPS metric, the Cash Flow per Share is also as widely employed as the EPS to evaluate a company’s performance. The Cash Flow per Share metric has been recently seen as a better indicator of a company’s performance, as it tracks the actual amount of money the company is able to bring in to fund future growth.
In today’s modern financial word, the creation of derivatives and complex financial instruments have sometimes challenged analysts in understanding the actual effect some securities may have in the distribution of earnings. While the most common instruments that come with exercisable rights are convertible issues, stock options and warrants, investors should be advise that creative financiers may do a significantly high effort to gather capital through new complex instruments that in the long run may end up affecting the ownership structure. For this reason, carefully reading the financial statements notes will provide guidance into any the existence of these securities and how they would affect the current number of outstanding shares.
On the other hand, since Earnings per Share are the result of deducting all expenses from the business’ revenues, there are times when businesses undertake extraordinary expenses related to mergers, acquisitions, restructuring processes and so on. While these items may seem large in some cases, their effect on the EPS pattern should be properly understood. If they are a one time item, the EPS figure may be adjusted for the purpose of analyzing the business’ earnings trend, as the items are non-recurring and their effect is limited to the time period when they occurred.