As the name suggests, earnings per share (EPS) represents the net earnings of a period that are attributable to each share of the common stock (ordinary shares). It is a financial ratio representing an entity’s ability to generate profits for its shareholders.
Formula to calculate EPS
Numerator of the formula: The aim is to arrive at the profit or earnings figure that is attributable to the ordinary shareholders.
Net profit is distributed to the holders of any preference shares, and after that, the remaining profit is available for distribution to the ordinary shareholders of a company. Whether it is distributed as dividend or retained in the business, either way, it is the net amount generated by the business for its shareholders.
Denominator of the formula: Number of shares could have been the ordinary shares outstanding at the beginning or end of the financial period. Why weighted average number of ordinary shares outstanding during the financial period are used?
Using the weighted average number of ordinary shares outstanding during the period reflects the possibility that the earnings may be varied due to varied capital during the period as a result of a larger or smaller number of shares being outstanding at any time. In other words, EPS is adjusted to account for the effect of varied capital to accurately reflect the financial performance of the business.
The weighted average number of ordinary shares outstanding during the period is
The number of ordinary shares outstanding at the beginning of the period,
The number of ordinary shares issued during the period multiplied by a time‑weighting factor.
The number of ordinary shares bought back during the period multiplied by a time‑weighting factor.
The time‑weighting factor is the time (in terms of months or days) that the shares are outstanding as a proportion of the total time in the period.
Uses of EPS
As with majority of the financial ratios, EPS of a period viewed in isolation would not be a very useful thing. However, it becomes a useful tool to analyse the profitability of a business if it is compared with EPS of other periods, or EPS of other similar companies in the same industry.
Investors are always interested in profits… how much money they’ll get out of their investment. When investors are about to invest in a business, they evaluate various options. They look at the potential earnings in relation to the share prices, and for doing so, they analyse the Price Earnings ratios (P/E ratios) of various options available for investment. EPS is used to calculate P/E ratio which is evaluated to conclude which shares are relatively cheap or expensive.
- A relatively lower P/E ratio suggests that share price is relatively cheap (a good option for the investor)
- A relatively higher P/E ratio suggests that share price is relatively expensive (not a good option for the investor)
However, EPS and P/E ratios are not the only factors and investors evaluate a lot of other information before making a decision about their investments.
Let’s go through a basic example showing the calculation of EPS.
Example – EPS
ABC company is preparing its financial statements for the year ended 31 December 2021. Draft financial statements have been prepared but the accountant is not sure how to calculate EPS to be disclosed in the income statement. He has asked you to help him out. Following information is available:
- Authorized share capital – 1.5 million shares of $1 each.
- Issued and paid up capital – 1 million shares of $1 each.
- New shares issued on 1st of February 2021 at market value – 200,000 shares
- Due to stability in business, shares bought back on 1st of November 2021 – 300,000 shares
- Preference dividend to be paid is $250,000.
- Net profit for the year is $4,000,000.
EPS will be calculated as follows.
The above information is related to basic EPS. For users of financial statements, in addition to basic EPS, another ratio called diluted EPS is also presented in the income statement. Diluted EPS is calculated assuming all the potential ordinary shares such as convertible debentures, share options etc., have been issued and are outstanding during the period.