There are many fundamental indicators that investors use to evaluate companies. One of the most important ones is Earnings Per Share. It allows investors to quickly and efficiently determine the financial health of a company. Such information is then used by them to make informed investment decisions. Wondering what EPS is and how it is calculated? Here’s a comprehensive guide that can help you clearly understand the concept.
Earnings Per Share, also known as EPS, is a fundamental financial metric. It indicates just how much of a company’s income its shareholders would receive for every share held by them if the said company chooses to distribute the entirety of its income.
When calculating Earnings Per Share, the net income of the company is considered. The net income is arrived at after subtracting expenses like interest payments, preferred share dividends, and taxes from the gross income.
By calculating EPS, you can quickly ascertain the level of profitability of the company. The higher the Earnings Per Share of a company, the higher its profitability is and the better it is likely to be as an investment.
Open Your free Demat Account in just 5 minutes!
Now that you’ve seen what EPS is, let’s take a look at the different types. Companies usually publish two different types of Earnings Per Share figures in their financial statements. One is the basic EPS and the other is the diluted EPS. Continue reading to find out more about each of these two types.
The basic Earnings Per Share takes the net income of the company and the weighted average number of outstanding shares into account. The reason that the weighted average is taken into account is because the number of outstanding shares may change during a year due to corporate actions such as fresh issues or buybacks.
The diluted Earnings Per Share is a mild variation of the basic EPS. It also takes the company’s net income into account. However, along with the weighted average number of outstanding shares, diluted EPS also considers convertible securities such as preferred shares, bonds, or debentures that can be converted to common stock at the end of their respective tenure.
Since diluted Earnings Per Share takes all of the future convertibles into consideration, it is usually regarded by investors to be a more accurate portrayal of the company’s profitability.
Generally, all companies publish both basic EPS and diluted EPS in their financial statements. However, although this information is easily available, as an investor, you still need to know how it is calculated. Here’s the mathematical formula used to determine a company’s Earnings Per Share.
Basic EPS = Net Income ÷ Weighted Average Outstanding Shares
Diluted EPS = Net Income ÷ Weighted Average Outstanding Shares + All Share Convertibles
Here, all share convertibles include all kinds of securities such as bonds, debentures, and preference shares that can be converted to equity shares in the future.
Now that you’re aware of how to calculate EPS, let’s take up a hypothetical example to better understand the calculation.
Assume there’s a company ‘LMN Limited’. The company’s net income for FY23 after accounting for expenses such as preferred dividends, interest payments, and taxes comes up to Rs. 98 lakhs. The weighted average number of outstanding shares is 65 lakhs. The company has also issued around 1 lakh convertible debentures, which will be converted to 5 lakh equity shares on maturity. Additionally, the company has also issued 5 lakh convertible preference shares, which will be converted to 10 lakh equity shares on maturity.
With this information on hand, let’s try to calculate both the basic and diluted Earnings Per Share metrics for the company.
Basic EPS = Rs. 98 lakhs ÷ 65 lakhs = Rs. 1.51
Diluted EPS = Rs. 98 lakhs ÷ (65 lakhs + 5 lakhs + 10 lakhs) = Rs. 1.225
As you can see, the basic EPS is higher than the diluted EPS due to the lower number of outstanding shares. The basic Earnings Per Share of Rs. 1.51 essentially means that shareholders would receive Rs. 1.51 for every equity share held by them if the company chooses to distribute the entire net income earned by it during FY23.
As you’ve already seen before, Earnings Per Share is a good way for investors to find out if a company is profitable enough. However, it would be imprudent to make investment decisions based solely on the EPS figure of a company.
For instance, a company’s basic EPS is let’s say Rs. 45. Going by this figure alone, you may think that the company is profitable and a worthy investment. But you won’t have any perspective of how the company fares against its rivals or the industry. Assume that the industry’s average EPS is around Rs. 70. Now, does the company’s EPS of Rs. 45 still look attractive? Obviously not.
That’s why it is always important to measure a company’s EPS with that of its rivals and the industry average. This way, you can get a better picture of the company’s profitability and make an informed decision about whether it is a good investment or not.
With this, you must now be aware of what EPS is and how to calculate it. Fortunately, almost all companies in India publish their basic and diluted EPS figures in their financial statements themselves, eliminating the need to manually calculate them.
That said, when using Earnings Per Share to determine a company’s worth, it is advisable to also consider the EPS growth rate over the years. Ideally, a company’s EPS should increase from year to year. If you find that the metric is fluctuating unpredictably or declining every year, you may want to think twice before investing in it.