Earnings per share

Definition

Earnings per share (EPS) is a financial metric that indicates the portion of a company's profit allocated to each outstanding share of common stock. EPS is an important indicator of a company's profitability and is used by investors to assess financial health, compare performance across companies, and evaluate potential investment opportunities.

5 Must Know Facts For Your Next Test

1. EPS can be calculated using the formula: $$EPS = \frac{Net\ Income - Preferred\ Dividends}{Weighted\ Average\ Shares\ Outstanding}$$.
2. There are two types of EPS: basic and diluted. Basic EPS only considers common shares, while diluted EPS accounts for potential dilution from convertible securities or stock options.
3. A higher EPS generally indicates better profitability and can lead to an increase in a company's stock price.
4. Investors often use EPS to compare companies within the same industry, as it provides a standardized measure of profitability.
5. EPS is reported on the income statement and is a key component in calculating other important financial ratios, including the P/E ratio.

Review Questions

• How does earnings per share serve as a tool for investors when evaluating the performance of different companies?
  • Earnings per share helps investors compare the profitability of different companies by providing a standardized measure that reflects how much profit is attributed to each share of common stock. This allows investors to make informed decisions about which stocks may offer better returns relative to their investment. By analyzing EPS alongside other metrics like revenue growth and profit margins, investors can get a clearer picture of a company's overall financial health.
• Discuss the difference between basic earnings per share and diluted earnings per share and their implications for financial analysis.
  • Basic earnings per share only considers the actual number of outstanding shares, while diluted earnings per share includes all potential shares that could be created through conversions or options. This distinction is crucial for financial analysis because diluted EPS presents a more conservative estimate of profitability, reflecting potential future dilution. Analysts often prefer diluted EPS as it offers insight into how existing shareholders' ownership might be affected if all convertible securities were exercised.
• Evaluate how changes in net income impact earnings per share and discuss how this relationship influences investment decisions.
  • Changes in net income have a direct impact on earnings per share since EPS is calculated based on net income divided by the weighted average shares outstanding. When net income increases, EPS rises, which typically leads to a higher stock price as it indicates improved profitability. Conversely, if net income declines, EPS will fall, possibly triggering negative investor sentiment and leading to lower stock valuations. Understanding this relationship helps investors make strategic decisions about buying or selling shares based on a company's performance trends.

Related terms

net income: The total profit of a company after all expenses, taxes, and costs have been deducted from revenue.

dividend: A portion of a company's earnings distributed to shareholders, often paid in cash or additional shares.

price-to-earnings ratio (P/E ratio): A valuation ratio calculated by dividing the current share price by the earnings per share, used to evaluate the relative value of a company's shares.