EPS is considered as the most important metric for the financial analysts, external and internal stakeholders, management and for the prospective investors. It is measured to know the income earned/ loss incurred by each ordinary share during a reporting period and provides the performance of the business for the targeted period. EPS is measured by users of financial statements to understand regarding price earnings ratio. It is the indicator that shows how many years the earnings would have to be repeated to be equal to the share price of the entity.
The users of the financial statements use the EPS to know the “dividend cover”calculation. This measure is calculated by dividing the EPS amount for a period by the dividend per share for that period. It indicates how many times the earnings cover the distribution being made of the ordinary.
What is Earnings Per Share
Earnings per share is the process that helps to measure of how much earnings per share is earned by the company. EPS is calculated as a company’s net profit after tax less dividend of preferred shareholders divided by ordinary/common outstanding shares of its common stock. It is considered as the indicators of profitability of the company and is adjusted for extraordinary items and potential share dilution. Higher EPS indicates that the company is more profitable and the investors could feel safe during an investment.
The Formula of EPS is = Net Profit After Tax less Preferred Dividends / Number Ordinary Shares outstanding.
The objective of determination of EPS
International Accounting Standards Produce IAS 33 to demonstrate the importance of determining and calculating earnings per share. The objectives of this standard to prescribe principle for the determination and presentation of earnings per share and compare the results with the similar industry’s EPS to measure the performance of the company.
When does company uses EPS?
Usually EPS is used by such entity which shares are traded in public market i.e domestic or foreign stock exchange. The potential investors who wants to purchase the shares from the stock market firstly want to know about the EPS.
Basic Earnings Per Share
Basic Earnings per share is the EPS measurement that tells the investors how much the company’s net income to be allotted with the ordinary shareholders/equity share holders. This EPS helps to investors to invest in the company’ share and helps to increase the share price in the stock market.
Earnings per share is the portion of a company’s profit that is allocated to each outstanding share of its common stock. EPS is calculated by taking the difference between a company’s net income and dividends paid for preferred shares and then divided by the number of equity outstanding shares.
Calculation of Basic EPS
Say for example, X company reported its net profit after tax is $ 20 million and pays out $ 2 million dividends to its preferred shareholders. The total outstanding equity share was 11 million. What is the EPS of the X Company?
EPS = Net Profit after Tax – Dividends for Preferred Shareholders/ Number of Shares outstanding = $20 – $2/11 million Shares = $1.63/Share.
Thus this company’s earnings came to $1.63 per share.
Diluted earnings per share
Basic earnings per share formula takes the outstanding common shares of the company to calculate the EPS of the company but in the case of diluted earnings per share calculation, all convertibles securities are taken into account for EPS calculation.A company might have convertibles preferred shares or stock options that could be considered as the common stock for the time being. If the company taken into account the preferred shares, the EPS will be reduced and this is Diluted Earnings per Share. Point to be noted, Diluted EPS will always be lower than its basic EPS per share.
Calculation of Diluted EPS
Using our example as mentioned above, let’s say the company above has issued 2 million convertible preferred shares. In this case, the new earnings per share would be $1.38 ($18 million divided by 13 million).
Significance of EPS
Investors always concentrate on EPS to invest. A higher EPS stock will always be the first option of the investment. If a company has high EPS, it indicates that it has sufficient money to reinvest in the business or distributed to its shareholders in the form of dividend payments.
Limitations of EPS
Increasing Earnings is the indication that the company is doing well. But as a measure of a company’s financial health, the EPS have some limitations. A company may increase its EPS by reducing their shares through buy back share purchase. Hence, EPS may not give the correct result of all times and it may be fabricated and overstated. Through this process, a company can manipulate the EPS and investors invest their money considering this EPS. Another limitation is that a company’s outstanding debt is not considered to calculate earnings per share.
If two companies report same EPS but one have less capital to bring that income, the should be considered as better than its counterpart.However, this factor is not considered in the practical field.