When starting to invest in stocks you must first choose an appropriate stock to invest in. Many people find it difficult to determine if a stock is a good investment or not. For this, it’s vital to use selection criteria like financial ratios. The earnings per share (EPS) ratio, which may be used to determine a company’s earning potential, is one of the most significant variables in these circumstances.
What Is Earnings Per Share (EPS)?
Earnings per share (EPS) measures how successful a business is on a per-share basis and is a number investors frequently use to evaluate a stock or company. A company’s net income is subtracted from any preferred dividends before being divided by the number of outstanding shares to get to its earnings per share (EPS). A company’s earnings for the period is equal to net income minus preferred dividends, which is the amount of capital left over in a reporting period after all cash and non-cash expenses are subtracted. Due to the contractual entitlements to dividend payments that preferred stockholders have, preferred dividends must be deducted.
In both its annual (10-K) and quarterly (10-Q) SEC filings, a business reports its EPS in Consolidated Statements of Operations (income statements). When earnings are taken into account, an organization has two options: it can either distribute the cash to shareholders or reinvest it in the business. For a number of reasons, learning how to calculate EPS on your own is helpful.
How Is It Calculated?
Net income, commonly referred to as earnings, can be calculated as net income divided by the number of shares existing. In a more detailed calculation, the numerator and denominator are changed to account for shares that could be produced by options, convertible debt, or warrants. If the equation is modified for ongoing activities, the numerator is also more important.
The balance sheet and income statement are used to determine a company’s period-end amount of common shares, dividends paid on preferred stock, and net income or earnings. Because the number of common shares can fluctuate over time, using a weighted average for the reporting period is more practical.
The weighted average number of shares outstanding must take stock dividends and splits into consideration when determining how many shares are outstanding overall. The calculation may be made easier by some data sources by utilizing the total number of shares outstanding at the end of a period.
How To Use Earnings Per Share (EPS)
One of the most crucial metrics used to assess a company’s success on an absolute basis is earnings per share. It has a substantial impact on the price-to-earnings (P/E) ratio, where the EPS serves as the “E”. An investor can determine the value of a stock in terms of how much the market is ready to pay for each dollar of earnings by dividing a company’s share price by its earnings per share.
One of the various indicators you can use to choose stocks is EPS. Selecting a broker who suits your investment style is the next move if you’re interested in stock trading or investing.
For investors, comparing EPS in absolute terms may not mean much because common shareholders are not given direct access to the results. Instead, to assess the worth of earnings and how confident they are in future growth, investors will contrast EPS with the stock’s share price.
Basic Earnings Per Share vs. Diluted Earnings Per Share
Basic EPS does not account for the potential dilution from stock issuance by the business. If stock options, warrants, or restricted stock units (RSU) are part of a company’s capital structure and they are exercised, this could result in a rise in the number of outstanding shares on the market.
Companies also publish the diluted EPS, which assumes that all shares that might be outstanding have been issued, in order to more clearly show the effects of new securities on per-share earnings.
For instance, for the financial year that concluded in 2017, a total of 23 million shares might have been generated and issued from NVIDIA’s convertible instruments. If this amount is added to the number of shares that are now outstanding, the diluted weighted average shares will be 541 million + 23 million = 564 million shares. Therefore, $1.67 billion /.564 million = $2.96 is the company’s diluted EPS.
When calculating a completely diluted EPS, the numerator must occasionally be changed. For instance, a lender might in certain situations provide a loan that allows them to convert the debt into shares. The convertible debt’s shares should be counted toward the diluted EPS calculation’s denominator, but if that were to happen, the corporation wouldn’t have had to pay interest on the loan. In order to prevent the calculation of EPS from being manipulated, the company or analyst will in this situation add the interest that was paid on convertible debt back into the numerator.
A Negative EPS
Unsurprisingly, companies do not always generate positive revenue. EPS is negative when losses are accrued. It is also possible to refer to a negative EPS as a “net loss per share” because it provides precise information about the amount of capital the business lost for each outstanding share. Don’t, however, accept a low EPS at face value.
For instance, when creating treatments that are economically viable, biotech companies frequently experience years of financial loss. On the other side, startups usually need time to boost sales and revenue. If such a company is steadily cutting its losses and heading in the direction of a positive EPS indication, that’s a positive sign.
Similar to start-ups, established businesses must deal with substantial one-time costs, like write-offs for important investments. Even if this causes their returns to decline for a quarter or longer and the EPS to decrease, the long-term outlook does not have to be bleak. Therefore, there is no need to become alarmed if a negative EPS is an anomaly rather than an ongoing trend.
Conclusion
Earnings per share (EPS) is a fundamental success indicator used to compare the price of a stock to a company’s real revenue. Higher earnings per share are generally preferable, but one must also take into account the number of shares outstanding, the possibility of share dilution, and long-term success patterns. Share prices can drop or rise depending on whether a company’s EPS falls short of or exceeds analyst estimate forecasts.
