The earnings per share (EPS) calculation is used to gauge the value of a company’s stock by calculating the amount of the company’s net earnings that is allocated to each outstanding common share. The formula used to determine EPS is as follows:
\(EPS= \frac{Net\: income\:– \:Dividends \:on\: preferred \:stock}{Weighted\: average\: of \:outstanding \:common \:shares}\)
For instance, if a company’s net income was €40m, it paid out €2m in dividends on preferred stock and the weighted average number of its outstanding common shares was 20m, the formula for working out its EPS would be:
\(\mathrm{EPS} = \frac{40m\: – \:2m}{20m}\)
\(\mathrm{EPS}={\mathrm{€\:1.90}}\)
A few definitions
Outstanding shares
Outstanding shares are those owned by members of the public and investors, as well as restricted shares owned by individual members of the company. Outstanding shares do not include shares that have been repurchased by the company itself.
Preferred stock
Preferred stock often entails restricted voting rights for its holder and pays out a fixed amount in dividends. Preferred stock is subtracted from the net income because it takes precedence over common stock. Therefore, if the dividends on preferred stock total €2m, that money will not be available for common stock.
Weighted average
Weighted average is used to incorporate any changes in the number of shares over the period in question. For instance, if our company had 16m stocks in the first half of the year and increased that number to 24m in the second half, the weighted average would be worked out thus:
\(\mathrm{Weighted\: average}={\mathrm{Number\: of\: shares\: in \:first \:half}\times{Period \:covered\:+\:Number\: of \:shares\: in\: second\: half}\times{Period \:covered}}\)
So, where WA = weighted average over one year
\(\mathrm{WA}=\mathrm{16m\:x\:0.5\:+\:24m\:x\:0.5}=\mathrm{8m\:+\:12m}=\mathrm{20m}\)
Variations
The above EPS calculation is a basic version. It is possible to adapt the calculation to take into account common stock plus all its equivalents, such as convertible bonds and warrants, by adding these to the denominator. In this case the formula is referred to as ‘fully diluted’.
There are also different forms of EPS depending on the time period used: trailing (using past figures), current (using this year’s figures) and forward (using projected figures).
When is EPS used?
EPS is useful when comparing different companies’ shares to assess their relative values and is used in the Price Earnings to Growth (PEG) ratio which is used to reveal the market value of a share’s growth potential. Basic EPS is also widely used in the US, where the Financial Accounting Standards Board (FASB) requires companies to report it on their income statements. Companies with complex capital structures must report both basic and diluted EPS.
A word of warning
EPS is best used as one of the measures of the value of a company’s stock. It is not possible to use it to get an exact valuation because other relevant factors are excluded. Most importantly it does not take the market value of the stock into account and its use is therefore limited.
