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Earnings per share (EPS) measures the amount of total profit earned per outstanding share of common stock in a specific period, usually either a quarter or a year. It’s one of the most fundamental financial metrics, and in conjunction with the price-to-earnings ratio, allows investors to gauge the stock price relative to a company’s profits.

Knowing a company’s EPS can be essential for making an informed investment decision, as a growing EPS usually leads to an increase in the stock’s price. However, it is important to consider other metrics to get a fuller understanding of the company’s health.

Here’s what you need to know about EPS, how to calculate it and its limitations.

How to calculate EPS and how it works

To find EPS, take the company’s net income (and deduct preferred dividends, if applicable) and divide that by the average number of shares of outstanding common stock.

Here’s the formula:

Earnings per share = ( Net income – preferred dividends ) / Outstanding shares of common

The resulting EPS tells you how much a company is earning for each outstanding share of stock. By providing a common base metric, EPS makes it easier to compare companies, each of which has a different number of outstanding shares, stock price and profits.

When calculating EPS, sometimes investors may use the weighted average of shares at the beginning and ending period being measured (say, a full year) in the denominator to give a broader picture of EPS. Other times, investors use the number of shares at the end of the period since it’s the most current and it’s the figure that the company is moving forward with.

EPS plays a key role in calculating the price-to-earnings ratio (P/E ratio) and helps investors understand the price they’re paying for every dollar of the company’s earnings. The P/E ratio has two key components:

  • Price is the price of the company’s stock.
  • Earnings is the per-share earnings, represented by EPS.

Divide the stock price by earnings per share and you get the stock’s P/E ratio.

With EPS and the P/E ratio, investors have an easy way to compare companies, letting them quickly judge the profit represented by each share of stock and how much they’re paying for it.

How does EPS affect a stock’s price?

Over time a stock price fluctuates with expected future changes in EPS. If a company can quickly grow its EPS, then its stock will likely rise. But if its EPS is falling over time, the stock will tend to follow.

  • A growing EPS tends to lead to a higher price investors are willing to pay for the company’s shares. A higher EPS generally indicates that the company performed well and can increase its stock price, making it more desirable to investors.
  • A falling EPS usually leads to a lower stock price, and investors may be uncertain how far earnings will fall and if the company will be able to increase its stock price.

However, the expectations set by analysts also play a role in determining the impact of EPS on the stock price. If a company reports solid EPS growth but falls short of analysts’ expectations, it may lead to the stock price remaining stagnant or even declining in the short term.

It’s important to understand that there is no benchmark for what a “good” EPS is. It’s simply a factual measure of the company’s profit per share. However, the P/E ratio can help investors understand whether they’re paying a lot for the company’s earnings or a little.

For example, a startup tech company with a lot of potential may have a lower EPS than an established healthcare company. But investors may be willing to pay a higher P/E ratio for a smaller, faster-growing company than a slow-growing or stagnant company.

EPS limitations

EPS by itself doesn’t tell you that much about a company, but rather offers a picture of profitability at a point in time, often a given quarter or year. So EPS alone doesn’t tell you if a company’s profits are rising or falling, though you could compare EPS over years to see how the company is performing or review analysts’ estimates to see how it might do in the future.

EPS may not provide the fullest measure of a company’s cash flow. The calculation of EPS relies on net income, which includes non-cash expenses such as depreciation and amortization, which are non-cash expenses. So a company may be generating much more cash flow than its EPS numbers suggest.

Additionally, companies can alter their EPS figures by changing the number of shares outstanding through actions like share issuances, stock splits or stock buybacks. To note, stock buybacks have a less certain impact on EPS because while they may reduce the number of outstanding shares, thereby increasing EPS, the decrease in cash on hand may reduce investment in the company. Additionally, share issuance and stock splits could dilute earnings per share.

What is diluted EPS?

The calculation of diluted EPS takes into account the impact of convertible securities and employee stock options that could dilute the company’s earnings per share. So, if a company has securities that could increase the number of shares outstanding, diluted EPS will be lower than basic EPS.

Calculating diluted EPS can be somewhat complicated, but here’s the formula:

Diluted EPS = ( Net income – preferred dividends ) / ( Outstanding shares of common stock + conversion shares )

The result here gives investors a broad picture of the earnings per share if all convertible securities were converted, factoring in the potential dilution to EPS from them.

What is adjusted EPS?

Financial statements often include not only the basic or diluted EPS, but also a measure called adjusted EPS. Adjusted EPS is calculated by modifying the numerator of the EPS calculation to eliminate one-time losses or profits such as legal fees or settlements, acquisitions, impairments, restructuring charges, a gain or loss on sale, or a one-time income tax gain or loss.

Management teams often tout adjusted EPS as a better estimate of the company’s core performance. That may be the case sometimes, but when “one-time” losses recur quarter after quarter, smart investors begin to take the adjusted EPS figures with more than a grain of salt.

Still, adjusted EPS can sometimes provide a better “look-through” on the company’s profitability and performance, if the metric is not abused by management teams.

Bottom line

EPS is an important metric used to assess a company’s profitability from a fundamental perspective. But it’s only one part of the picture for assessing whether a stock is worth buying. Other financial metrics can also give investors a fuller view of the company and its prospects.