Earnings per share EPS measures the profitability of a company. The formula to calculate it is the following:
EPS = Net Outcome / No. of Outstanding Shares
Example: Company XYZ has a revenue of $10,000,000 and expenses of $7,000,000 the net income is $3,000,000 ($10,000,000-$7,000,000).
Company XYZ has 2,000,000 outstanding shares so the EPS in this case is $1.5 ($3,000,000/2,000,000).
Note: A lot of investors consider the EPS before buying stocks, as well as people in the stock market.
EPS is a financial ratio, when measured for a single company it can give an arbitrary value. When calculating it, you need to take into consideration the weighted average of the outstanding shares since they may change over the year. The formula to calculate it is the following:
EPS = Net Income / Weighted Average of Outstanding Shares
Example: Company XYZ has a revenue of $10,000,000 and expenses of $7,000,000 the net income is $3,000,000 ($10,000,000-$7,000,000).
Company XYZ had 1,000,000 outstanding shares until the end of Q2 and 200,000 shares at the end of Q4. so the EPS, in this case, is $5 ($3,000,000/600,000).
| Outstanding Shares | Period | Weighted Shares | |
| The first half of the year | 1,000,000 | 0.5 | 500,000 |
| The second half of the year | 200,000 | 0.5 | 100,000 |
| Weighted Average | 600,000 |
The diluted ratio is the second way to calculate the EPS and it considers all kinds of convertible shares, stock options, and warrants in the outstanding shares. The formula to calculate it is the following:
Diluted EPS = (Net Income – Preferred Dividends) / (Weighted Average of Outstanding Shares + Converted Shares)
Example: Company XYZ has a revenue of $10,000,000 and expenses of $7,000,000 the net income is $3,000,000 ($10,000,000-$7,000,000).
Company XYZ had 1,000,000 outstanding shares until the end of Q2 and 200,000 shares in the end of Q4. The company has 100,000 of 5% interest on bonds that wants to convert in stocks and will be taxed 30% on. There are 10,000 cumulative preferred stocks 4% nonconvertible, par $100.
Diluted EPS = [3,000,000-(10,000*.04*100)/(600,000+(100,000*.05*0.7))]
Diluted EPS = [3,000,000-40,000/600,000+3,500]
Diluted EPS = 4.90$
Note: 0.7 = (1 – 0.3) Tax
As you can see the diluted EPS is always lower than the basic EPS and this is because is consider as the worst-case scenario.
Equity Dilution refers to the decrease in the number of stocks holding by each shareholder. This is happening whenever there is a new offering or a new party (shareholder) joins the company either through IPO (Initial public offering), FPO (Follow on public offer), or private equity.
It is not a good sign for investors every time an equity dilution happens. The reason is, no matter if the company’s valuation increases since more money are invested in it, the equity holdings per shareholder decreases. For instance, the total number of shares issued increases, but the number of stock holdings for each shareholder remains the same. Hence, this has a negative effect on their percentage terms and causes them to reduce. This reduction is called equity Dilution.
No matter how important it is for investors to calculate EPS, it can give an arbitrary value if looked at alone. When analyzing two different companies the number becomes more valuable. Why is that? Identifying a higher EPS between competitors indicates a more profitable company thus, helps to form a more correct investment decision and vice versa.
EPS is typically calculated together with the share price (P/E ratio) to identify how cheap (low P/E) or how expensive (high P/E) the company’s share price is. P/E ratio is also referred to as earnings multiple. The P/E is calculated as follows:
P/E = Stock Price / EPS
A company that has is losing money or has a negative earning has no P/E because the EPS represents the E in this ratio. Furthermore, when P/E is below 15 is considered a cheap share price, and if it’s above 18 is considered an expensive share price but again there are no specific numbers that indicate that.
Example:
22 = P / 10
Earnings Yield is the EPS divided by the stock price, which means the reciprocal of the P/E ratio.
Earnings yield is calculated as follows:
Earnings Yield = EPS / Price
OR
Yearnings Yield = 1 / P/E
Expressed as a percentage.
Example:
Stock X has a value of $10 and its EPS for the last year was $1.20.
The P/E is 8.33 ($10/$1.20) and the yield on earnings will be ($1.20/$10) 0.12 or 12%.
Stock X has a value of $40 and its EPS for the last year was $3.
The P/E is $13.33 ($40/$3) and the earnings yield will be ($3/$40) 0.075 or 7.5%.
Let’s assume that these two stocks represent the same industry sector and have a very similar capital structure. Which one has a better value and why?
The answer is stock X. Stock X has a lower P/E compared to stock Y and it also gives a higher yield.
The earnings yield can make us understand that for every $1 dollar invested in the company the stock will generate 0.12 cents, compared to stock Y which will only generate 0.075 cents.
Note: Overall, investors find it easier to calculate the yield before deciding whether to undertake the investment or not.
In financial terms, moral hazard is the risk that appears when a party does not enter a contract in good faith or has provided false information regarding assets, liabilities or credit capacity. What does that mean? The party is able to take the additional or unusual risk to benefit or earn profit from the contract.
For example, when your house/business building etc. is not insured you will pay attention and take care of it but if your house is insured you will be reckless because your insurance will suffer the costs instead of you.
This is the case with diluted EPS, when they exist the management cannot harm the investors or mislead their profitability.
Dividends per share are the number or declared shares a company has for every ordinary share outstanding. Each shareholder of the company is getting paid a dividend share that represents the amount of investment they have in it. Ordinary shares or common shares equal one vote per share which gives shareholders the right to vote in annual meetings. The formula to calculate it is the following:
DPS = (Total Dividends Paid Out Over a Year – Special Dividends) / Shares Outstanding
Example: Company XYZ paid $200,000 in dividends to the shareholders and none of them were special dividends. The outstanding shares of the company are 1 million, so the dividends per share is $0.2 ($200,000/1,000,000).
EPS and dividend shares both represent a company’s strength or financial terms profitability but that’s all about it. As we said before, EPS represents how profitable a company is by taking into consideration the net income divided by the number of outstanding shares. On the other hand, dividend shares represent the portion from the company’s earnings that is paid out to the shareholders.
The net profit available to shareholders for EPS purposes is net profit reduced for dividends on preferred shares (shown in a diluted formula above). Dividends paid to preferred shareholders are not intended for common shareholders and must, therefore, deduct them when calculating EPS.
Thus, there are two types of preferred shares, cumulative and non-cumulative. When they are cumulative in question, the preferred shareholder’s entitlement is always deducted whether they are declared or paid. Dividends that take into account when calculating are only current.
When non-cumulative preferred shares are in question, the dividend is deducted only if it is declared.
If we have an example of a company whose net income at the end of the fiscal year is $5.6 million and weighted common shares $0.955 million with preferred dividends $0, then the basic EPS will be:
EPS = (Net Income – Preferred Dividends) / (Weighted Common Shares) = ($5.6m – 0 / $0.955m )= $5.86m
However, if it were an example that the total number of shares generated from the company’s convertible instruments at the end of the fiscal year is $ 54 million. In that case, we will have a diluted weighted average of shares. Then we add the value of $ 54 million to the total share outstanding of $ 0.955B, which is the total:
$955 million + $54 million = $1,009B
Then the diluted EPS at the end of the fiscal year will be according to the formula:
Diluted EPS = (Net Income – Preferred Dividends) / 1.009B =
5,6 / 1.009 = $5,5
This example is fictitious to show how to calculate basic and diluted EPS.
Whether EPS will be favorable depends on several factors. One of them is the recent performance and results of the company. Furthermore, the performance of competitors is important when it comes to comparing it with the sector the company operates in. In the end, it is important what traders expect from all that, what are their plans for buying shares, and with what strategy.
It can happen, for example, that the value of EPS increases and stock prices fall, and vice versa, with a decrease in the value of EPS, stock prices may rise. It is happening in line with analysts’ expectations, whether they predict a higher or lower result. The essential thing is to estimate the value of EPS concerning the share price, as in the case of observing the ratio of price and earnings P / E.
For more trading terms, check out our Stock Encyclopedia.
