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When investing in the stock market, a company’s profitability (or its expected future profitability) is all that matters.
If a public company demonstrates its ability to generate income at an increasing rate, its investors will be richly rewarded. Identifying the companies with the best chances to grow their bottom lines consistently over a long period of time is what successful stock-picking is all about.
On the other hand, if a company never turns a profit, then its stock price will reflect its dismal performance.
So how can you measure a company’s profitability?
It’s called earnings per share (EPS).
Earnings per share is the primary profitability input used by fundamental investors all over the world. In this article, we’ll break it down so that you can use it to make a profitable investment.
What is Earnings Per Share (EPS)?
Earnings per share (EPS) is a company’s net profit divided by the number of outstanding shares.
The resulting figure indicates a company’s profitability. The higher the number, the greater the profitability per share. The higher the profitability, the greater the number of investors wanting to buy a stake in the company, resulting in an increasing stock price.
Standing alone, an EPS figure is somewhat arbitrary. Yes, it can tell you if a company is profitable, but what really matters is the EPS of a company relative to others in its industry, relative to its own stock price (P/E ratio), and its own EPS over time.
Why Calculate the Earnings Per Share Formula?
Earnings per share is one of the most important financial metrics for fundamental investors.
When you buy a stock, you’re buying a piece of a company. Though you’re one step removed, you’re buying a sliver of that company’s profits or losses.
Remember, stocks are just really big companies, nothing more. When those companies generate profits, they then decide what to do with that cash, either distributing it in the form of dividends or stock repurchases or reinvesting back into the business to generate higher future profits.
In a very real sense, the earnings per share is what you’re buying every time you make a new investment.
Earnings Per Share Formula
Earnings per share is found by subtracting the preferred stock dividends from the net income. You divide that result by the average outstanding shares.
Keep in mind that since the number of outstanding shares can change over time, most formulas use the average over a specified period of time.
Let’s take a look at an earnings per share example.
Let’s say Company X earned $100,000 in profit in 2021, paid no preferred dividends, and has 10,000 shareholders.
The shareholders would see $10 in earnings per share ($100,000 in net income/ 10,000 shareholders).
Earnings Per Share FAQs
Next, we’ll look at the most commonly asked questions associated with earnings per share.
Q. What is a Good Earnings Per Share?
As mentioned earlier, a “good” earnings per share is completely relative:
- relative to its peers in the same history
- relative to its own stock price (P/E ratio)
- relative to its own history of profitability
A growing EPS figure indicates a company increasing in profitability. If the company is doing so at a faster rate than its competitors, investors can be expected to pile into the stock, sending the price of its shares higher. This is good news for those who already held the stock.
Similarly, a shrinking EPS figure reflects a company decreasing in profitability. When investors recognize this and the future looks bleak, there’s no telling how fast or how far a stock will fall.
Remember, short-term increases or decreases in earnings per share can result from one-time changes in expenses, depreciation, or lack of reinvesting for the future. Savvy investors concern themselves with long-term trends in earnings.
Q. Basic EPS vs Diluted EPS: What’s the Difference?
The basic EPS calculation can be seen in the formula above. To calculate the diluted EPS, shares which can be created from stock options, warrants, or restricted stock units (RSUs) are considered exercised and are added to the denominator.
For example, if Microsoft made $200 million in profit and has 50 million common shares outstanding, its basic EPS is $4 ($200 million / 50 million shares).
However, if Microsoft had distributed employee stock options which could potentially be converted into another 10 million shares, the diluted EPS is $3.33 ($200 million / (50 + 10) million shares).
Q. Earnings Per Share vs Dividend: What’s the Difference?
Although earnings per share is the leading measure for tracking a company's financial performance, investors don’t have direct access to those earnings.
If a company generates profits, its board of directors then decides what to do with those earnings:
- Retain them all for business development
- distribute a portion of them in the form of a dividend
A dividend is the portion of profits distributed by a corporation to its shareholders.
For example, if Apple generates $100 million in profits in a year, has 100 million shares outstanding, and decides to pay a 2% dividend, the company has $1 in EPS ($100 million / 100 million shares) and pays a $0.02 dividend per share.
In this scenario, after paying out $2 million worth of dividends, Apple is left with $98 million (98 cents per share) in retained earnings to add to its stockpile of cash and reinvest back into the business.
Q. Can a Company have a Negative Earnings Per Share?
As we see in the formula, earnings per share is a company’s net income divided by the number of outstanding shares. If a company is unprofitable (spending more money than it makes), it will have a negative net income (a net loss), thus giving it a negative EPS.
Unintuitively, there are many public companies that maintain a negative EPS for years and can even boast a soaring share price throughout that same period. In these scenarios, investors are expecting the company to perform well in the long run, perhaps being a front-runner in a new industry.
The Bottom Line: Earnings Per Share
Although a company’s EPS has little to say about whether or not it's a good investment on its own, it’s an essential metric for all of the formulas that do determine investment decisions.
It’s also the entire crux of investing: You invest in a company for its ability to generate profits, ideally at an increasing rate. Forgetting this simple truth has taught many lessons to purely speculative investors since the beginning of the stock market.
Unfortunately, it’s also a lesson that too many investors learn firsthand.