What is Earnings Per Share (EPS)?

Earnings Per Share (EPS) is an important financial metric which is calculated by dividing the total earnings or the total net income with the total number of outstanding shares and is used by investors to measure the company’s performance and profitability before investing, the higher the EPS the more profitable the company.

Explanation

It is only reported for shares of common stock
Non publicly traded firms are not required to disclose EPS calculations
It provides insight into common shareholders about:
- Future dividend payout
- The value of their shareholdings

When you analyze a company’s financial health, the very first measure that you may want to check its profitability. The portion of a company’s profit allocated to each outstanding share of common stock is known as EPS. Though its interpretation is relatively easy, however, the calculation is not this simple. For example, let us have a look at the Colgate Palmolive Earnings Per Share Schedule.

source – Colgate 10K filings

We note that there are two variations – Basic and Diluted EPS in Colgate. Also, note that stock options and restricted stock units are affecting the total number of shares outstanding. If this is slightly confusing at this stage, then worry not; the primer on EPS covers the basics and then takes you to the advanced level of Earnings Per Share.

Simple vs. Complex Capital Structure

A company’s capital structure is simple if it consists of only common stock or includes no potential common stock that, upon conversion or exercise, could dilute earnings per common share. Companies with simple capital structures only need to report basic EPS formula.

A complex capital structure has securities that could have a dilutive effect on earnings per common share. As of now, think of the dilutive effect as those securities that lower the Earnings Per Share.

Complex capital structure has potentially dilutive securities like convertible securities, options, or warrants.
Companies with complex capital structures must report both basic and diluted EPS calculations.
Diluted EPS calculation under a complex capital structure allows the investors to see the adverse impact on EPS if all diluted securities convert into common stock.

Let us look at the Colgate example again in this context. Colgate has a complex capital structure – Why? The reason is that their capital structure contains stock options and restrictive stock units that may increase the number of shares outstanding (denominator). If the number of shares outstanding increases, then the EPS will decrease. Please note in the case of Colgate, the number of shares that increase due to stock options and restricted stock units is 9.1 million for the year 2014.

source – Colgate 10K filings

Earnings Per Share Formula

The basic EPS formula does not consider the effect of any dilutive securities. Here we use the actual earnings and an actual number of issued common shares issued.

EPS calculation in a simple capital structure is as follows

The current year’s preferred dividends are subtracted from net income because EPS refers to earnings available to the common shareholder. Common stock dividends are not subtracted from net income.

Since the number of common shares outstanding may change over the year, the weighted average is used to calculate EPS. The weighted average number of common shares is the number of shares outstanding during the year weighted by the portion of the year they were outstanding. Analysts need to find the equivalent number of whole shares outstanding for the year.

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Three steps to calculate the weighted average number of common shares outstanding:

Identify the beginning balance of common shares and changes in the common shares during the year.

For each change in the common shares:

Step 1 – Compute the number of shares outstanding after each change in the common shares. The issuance of new shares increases the number of shares outstanding. The repurchase of shares reduces the number of shares outstanding.
Step 2 – Weight the shares outstanding by the portion of the year between this change and next change: weight = days outstanding / 365 = months outstanding / 12
Step 3 – Sum up to compute the weighted average number of common shares outstanding.

EPS Calculation Examples

Example #1

Let’s take a practical example to illustrate the earnings per share formula.

Hit Technology Inc. has the following information –

The net income for the year-end 2017 – $450,000
The preferred dividends paid in 2017 – $30,000
At the beginning of the year 2017, the common shares outstanding were 50,000 shares. In the middle of the year, Hit Technology Inc. issued another 40,000 common shares.

Find out the earnings per share of Hit Technology Inc.

In the example, we know the net income and the preferred dividends. That means we know all the information needed for the numerator. However, we don’t know the weighted average of common shares outstanding; because we need to calculate that from the data given.

Let’s calculate the weighted average number of common shares outstanding first.

It’s said that at the beginning of the year, the firm had 50,000 common shares. And in the middle, 40,000 new common shares were issued. It means we can consider 50,000 shares for the entire year and 40,000 shares for the last 6 months.

Here’s the calculation –

Weighted average number of common shares = (50,000 * 1) + (40,000 * 0.5) = 50,000 + 20,000 = 70,000 shares.

Now, we will find out the EPS formula –

EPS formula = (Net Income – Preferred Dividends) / Weighted Average Number of Common Shares
Or. EPS formula = ($450,000 – $30,000) / 70,000
Or, EPS = $420,000 / 70,000 = $6 per share.

Example #2

Let us take the example of Colgate from the above example, the Net Income (2013) attributable to Common Shareholders is $2,241 million, and common shares outstanding is 930.8 million. EPS calculation of Colgate for 2014 is $2,241 / 930.8 = $2.41

source – Colgate 10K filings

Example #3

Albatross Inc 2007 Net Income – $1,000,000. Additional data provided below

100,000 Class A shares preferred cumulative shares, dividend amount of $2.00/share
50,000 Class B shares preferred noncumulative shares, dividend amount $1.50/share
No Dividend declared or paid in the current year

What will be the numerator of basic EPS for Albatross Inc?

The numerator of EPS = Net Income – Preferred Dividends

The weighted average number of shares calculation

The weighted average number of shares is calculated as per below –

Effect of Stock Dividends & Stock Splits

In computing, the weighted average number of shares, stock dividends, and stock splits are only changed in the units of measurement, not changes in the ownership of earnings. A stock dividend or split shareholders).

When a stock dividend or split occurs, the computation of the weighted average number of shares requires the restatement of the shares outstanding before the stock dividend or split. It is not weighted by the portion of the year after the stock dividend or split occurred.

Specifically, before starting the three steps of computing the weighted average, the following numbers are restated to reflect the effects of the stock dividend/split:

The beginning balance of shares outstanding;

All share issuance or purchase prior to the stock dividend or split;
No restatement is made for shares issued or purchased after the date of the stock dividend or split.

If a stock dividend or split occurs after the end of the year, but before the financial statements are issued, the weighted average number of shares outstanding for the year (and any other years presented in the comparative form) must be restated.

Effect of Stock Splits & Stock Dividends

Calculate the weighted average number of shares for the following –

The weighted average number of shares is calculated as per below –

Colgate’s Stock Dividends –

As a result of 2013, Stock Split all historical per share data and numbers of shares outstanding were retroactively adjusted. In 2012, the shares outstanding were 476.1 million, and they almost doubled up to 930.8 million due to the two-for-one stock split.

source – Colgate 10K filings

How Earnings per Share is related to the Stock Markets

Earning represents the profitability of the company and is considered to be the most important indicator of the financial health of the company. Earnings are reported four times a year by the publicly listed companies, and we note that research analysts and investors closely follow this earnings season. Growing earnings or EPS is a measure of a company’s great performance and, in a way, a measure of returns for the investor. In fact, EPS is direct to the stock markets by the way wide tracked Wallstreet PE Multiple or Price/EPS ratio. The lower the PE multiple compared to the Industry average PE, the better it is from the point of view of investments and valuations. Stock prices react sharply to quarterly earnings due to the very same connection. For example, below is the share price movement of Blackberry Ltd after the quarterly earnings report. Note the sharp movements in the stock prices. Learn more about Enterprise Value and Equity Value here

source – Reuters