What is EPS in stocks? Earnings per share, why it’s important, how it's used
The dates when companies release earnings are key for traders and investors. Performance over the past quarter and guidance for the year influence the share price by changing investors’ expectations.
EPS or earnings per share helps to capture the results in a single number.
In this post, we’ll explain what is meant by EPS, one of the most important financial metrics.
What is earnings per share?
Without going into accounting definitions, the company’s ‘earnings’ are simply profits (i.e. revenue minus costs).
Earnings per share are exactly that: earnings divided by the number of shares. EPS answers a simple question: “how much profit is made for each share?”
Why is this important?
A consistently growing EPS implies that the company is creating value for investors. Similarly, a declining EPS might signal problems. That’s why it’s the headline number for financial journalists. It’s also a key output for Wall Street analysts who prepare their estimates ahead of every earnings release. The average of these estimates is known as consensus estimate.
How EPS is calculated
The general EPS formula is simple. Earnings per share is calculated by dividing the profit (also known as net income) by the number of shares.
The number of shares outstanding simply means the stock held by all parties, including investors and company executives (you can find this on the company's balance sheet).
There are slight variations in the way EPS equation is applied by different organisations or under different accounting standards, but this is largely irrelevant for you – you don’t have to calculate it yourself.
How is earnings per share used
EPS is an important barometer that shows investors how the company is doing.
Reacting to “missed earnings” and “beating estimates”
You might have heard these cliches in the media. If a company has “beaten” or “exceeded” the estimate, that means the reported figures have exceeded the Wall Street analyst consensus. Similarly, if a company has “missed” earnings, that's because the reported figure came below what was expected.
- If the overperformance was a surprise, the share price is likely to go up after the earnings announcement;
- If the underperformance was a surprise, the share price is likely to go down;
- It might also be the case that the market has priced in the discrepancy between the estimate and the released figure – the price somehow reflected the information and hence will not change.
Calculating PE ratio
If you know the EPS, you can also calculate another important metric: the price / earnings ratio. Simply divide the share price by the EPS.
This PE ratio lets you quickly compare different companies or even different industries:
- Fast-growing companies and industries have high PE ratios as investors anticipate that more profits will come in future;
- Stable companies have lower PE ratios – investors assume that profits will remain the same;
- Declining industries show even lower PE because investors expect that things will only get worse.
Wall Street analysts estimate earnings per share by building financial models that try to predict the income statement of the company. To do that, they are relying on past financial statements and additional data sources, such as competitors’ statements, market reports, industry news, consumer trends, and other fundamentals.
It’s important to remember that EPS does not depend on the current share price, so technical analysis won’t help here. You should look at the industry, the company’s fundamentals, its peers, and the wider picture in the news.
Because earnings per share is so important for the markets, corporations might try to manipulate their EPS. In other cases, some events distort earnings, making it look to high or low. That's why analysts some times make adjustments to EPS.
- Earnings per share excluding extraordinary items. If a company received a huge penalty it would make a temporary dent in profit, leading to a temporarily lower EPS. Similarly, if a company sold its office building at a profit, this would boost its earnings per share. These events are 'extraordinary', i.e. they don't happen every year. So analysts would exclude them from calculating the company's earnings if look at the longer term.
- Earnings Per Share from Continuing Operations. If a company sold some of its profit-generating assets, then net income would be lower in future. When calculating earnings per share, analysts might exclude profit contribution from businesses that are sold or shut down.
Basic EPS vs Diluted EPS
You might also come across the term "diluted EPS". That's the earnings per share that would result if the number of shares increases because all options are exercised, convertible bonds are turned into common shares, and so forth. Of course, diluted EPS would always be lower than basic EPS that we reviewed above.
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