When considering which stocks to invest in, we need to analyze each security and look for the most viable investment. For instance, we would do well to calculate earnings per share, commonly shortened as EPS: Not only does it let us know what kind of return on investment we can expect from buying the stock, but it is also used in several other ratios, all of which are instrumental in figuring out the expected return of an investment. So, throughout this article, we are going to look at how to calculate earnings per share, what different types of this figure exist, and what factors can affect it. But first, we need to answer the most basic question of all:
What is Earnings Per Share?
Upon going public, a company issues shared to be owned by the public, and each share represents partial ownership of the company. With that in mind, if we’re to assume that a company’s overall objective is to generate a profit, then when we calculate earnings per share, we are basically measuring how much of a win each shareholder can look forward to. In other words, assuming that all the profits a company makes are paid to its shareholder, this measure tells us just how much money each shareholder should expect.
Diluted Earnings Per Share?
A special case that can affect how we calculate earnings per share appears in the case of diluted earnings per share. This is a conservative measure that takes into account all the outstanding shares as well as all convertible securities such as convertible preferred shares, stock options, warrants, and convertible debentures. The idea is to consider the worst case scenario, a scenario where all convertible securities are exercised, and to calculate earnings per share. Consequently, it is a safe assumption that the diluted earnings per share are usually smaller than the earnings per share.
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How To Calculate Earnings Per Share
The earnings per share formula is simple enough:
EPS = (net income – preferred dividends) / average number of outstanding shares.
Let’s take a moment to dissect all the terms in the earnings per share formula:
- Net income:
The net income of a company is all the profits it makes minus all its expenses, including operating costs, interest rate payments, and taxes. It’s the total amount of money the company gets to walk away with at the end of the year. It is one of the main components we use to calculate earnings per share
- Preferred dividend:
When paying shareholders dividends, a company has to prioritize individuals who own preferred stock over those who own common stock. And, seeing as the earnings per share formula is concerned with the fortunes of common stock owners, we deduct the preferred dividends a company has to pay.
- Average number of outstanding shares:
As we mentioned earlier, the existence of convertible securities means that the number of outstanding shares will always be in flux. Therefore, we use the average number of shares to compensate for this.
With regards to diluted earnings per share, the formula is very similar except for one change to the denominator: We replace the average number of shares with the sum total of outstanding shares and shares that would result from cashing in on convertible securities.
The final formula looks something like this:
Diluted EPS = (net income – preferred dividends) / (total number of outstanding shares + number of shares resulting from the conversion of all available convertible securities)
A quick illustrative example:
We can check that we understand how to calculate earnings per share by looking at the stock of Apple at the beginning of the third quarter in 2018.
At the time, its net income over the previous three months was around 11.5 billion dollars.
The number of outstanding shares was 4.882 billion, whereas the number of convertible securities amounted to 44.442 million.
Finally, Apple didn’t have any preferred stock at the time, so the value of the preferred dividends is equal to 0.
We are now ready to calculate earnings per share for Apple stock during the second quarter of 2018:
EPS = 11.5/4.882 = $2.36
Diluted EPS = 11.5/(4.882+0.0444) = $2.34
It’s that simple.
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Different Types of Earnings Per Share
One thing we should point out is that when we calculate earnings per share, the time period over which this calculation takes place has a great influence over the final result; after all, the amount a company earns over three months is less than what it makes in a year. Therefore, we need to be clear on which net income we are using to calculate earnings per share: Is it the net income of the past three months, six months, or the entire year?
Just as the EPS varies according to the time period we are accounting for, it also differs depending on when we are calculating it, meaning that last year’s EPS is bound to be a little different from this year’s EPS, which will also differ from next year’s. This brings us to the concept of Trailing EPS, Current EPS, and Forward EPS:
In this case, we calculate earnings per share using the previous four quarters of earnings, hence relying on actual numbers rather than projections. As a result, most analysts calculate earnings per share in this manner as it reflects actual events rather than possible future scenarios.
However, seeing as a trailing EPS represents old events, some investors are concerned with this measure’s relevance for future events. In other words, it is important to bear in mind the correlation between trailing EPS and future events.
In this case, we calculate earnings per share using the four quarters of the current fiscal year. Accordingly, some of the data used in the earnings per share formula will be based on actual numbers whereas the rest of it will be reliant on future projections.
In this case, we calculate earnings per share using projections for a future period in time, which is usually the approaching four quarters. Obviously, this figure can be evaluated by analysts trying to evaluate the company’s performance or by the company itself trying to set expectations for the coming year.
Despite being based on estimates, the forward EPS is of major interest to most investors as it signals what is to come and how a company’s immediate future is looking. What’s more, investors are bound to compare different earnings per share measures with one another in order to assess how accurate the future projections are.
Factors That Can Affect EPS
From the earnings per share formula, we can surmise that there are three main factors that can influence how we calculate earnings per share:
- A change in the earnings of a company.
- A change in the number of convertible securities.
- A change in the number of outstanding shares.
Even though the first two cases are fairly self-explanatory, the third case, that of a change in the number of outstanding shares, deserves more attention.
We already know that the number of shares can increase if plenty of convertible securities decide to change. However, they can also decrease if a company decides to buy back some of its own shares, which, according to the earnings per share formula, will increase that company’s EPS. Generally speaking, companies choose to buy back their shares when these shares are underpriced, making the buyback a win for the investors.
Why Do I Need to Calculate Earnings Per Share?
There are many benefits that can come trying to calculate earnings per share:
• For starters, a company that has a high EPS is a company that can pay its stockholders more handsomely than a company with a low EPS. Accordingly, investors tend to compare two companies by looking at their respective EPS figures, which can give a helpful measure if both companies operate within the same industry.
• Also, when we calculate earnings per share for several consecutive time periods, we look at how a company has been performing over these time periods. Put differently, if a company’s EPS has been increasing steadily over the past few years, this gives investors an impression that this is a stable investment, while a company with a volatile or even decreasing EPS can come off as worrying.
• Over and above, the EPS is instrumental in calculating the price-to-earnings ratio, P/E ratio, a ratio that is used to assess the attractiveness of a stock as an investment. In fact, the P/E ratio is arrived at by simply dividing the price of a stock by its earnings per share. And, although this metric might seem simple to come by, it offers investors plenty of valuable information, such as whether a company is mispriced in relation to its peers or not.
Putting it All Together
Having learned why we need to calculate earnings per share, we are now better equipped to go out and start analyzing securities. We can either compare historical EPS of a single company or compare the EPS of different companies that operate in the same industry. All that being said, we should always use more than one measure in our analysis in order to gain a more holistic view of a security’s performance.