Earnings Per Share

Broad Definition of Earnings Per Share

The term Earnings per Share (EPS) represents the portion of a company's profit that is allocated to each outstanding share of common stock. It serves as an indicator of a company's profitability, interpreted broadly as the "earnings" or profit made per each share held.

How Earnings Per Share influence Corporate Finance

EPS plays a significant role in corporate finance. It's one of the numbers that analysts look at when deciding whether to invest in a company's stock. Companies strive to keep their EPS as high as possible as it directly impacts investors' perspectives.

Could Earnings Per Share Increase?

Yes, a company's Earnings per Share can increase. This could be due to an increase in net income, reduction in outstanding shares, or both. Here's how it could happen:

• Increased net income: If a company's net income increases while the number of shares remains unchanged, the Earnings per Share will increase.
• Reduced outstanding shares: If a company reduces its number of outstanding shares through share buybacks while net income remains unchanged, the Earnings per Share will increase.

Impact of Earnings Per Share Increase on Investors

An increase in Earnings per Share is often a good sign for investors. It could signal that the company is becoming more profitable, and investors may expect higher dividends and capital appreciation. However, it's crucial for investors to consider other financial ratios and a company's overall fiscal health, as the EPS alone may not tell the entire story.

The Mathematics behind Earnings Per Share

Understanding the intricate calculations that allow us to arrive at the Earnings Per Share (EPS) is a pivotal part of comprehending company financials and the implications these can have for investors and shareholders alike. Let's delve into the fascinating details of the mathematics so you can firmly grasp the concept.

Breaking Down the Earnings Per Share Formula

The formula to calculate the Earnings Per Share is straightforward but carries immense value for investors looking to understand a company's profitability relative to the shares they own. The formula is as follows:

• Net Income: This is essentially the company's total earnings or profit after subtracting all costs, including operational expenses, cost of goods sold (COGS), interest payment, taxes, and other expenses.
• Dividends on Preferred Stock: Those dividends, generally fixed, paid to preferred stockholders should be subtracted from net income as EPS only applies to common stock, excluding preferred stock.
• Number of Outstanding Shares: This indicates the total number of shares of a corporation's stock that are held by shareholders, including both institutional investors and individual retail investors.

Basic Earnings Per Share: The Simple Calculation

To process the EPS formula, you only need the numbers presented on a company's financial statements. Let's start with the net income. You'll find it on the company's income statement, usually the bottom line, as it’s calculated after all operating costs, taxes, and other expenses, are deducted from the company's total revenue. The dividends on preferred stock also appear on the annual financial statement. Since preferred dividends are earnings not available to common stock shareholders, it's essential to subtract them to calculate the correct EPS. The average number of common shares outstanding over an accounting period, typically a year, is found in the shareholder equity section in the balance sheet. After having gathered these numbers, it's a straightforward task to input them into the EPS formula.

Earnings Per Share Example: Putting Numbers to the Formula

Let's consider an example of company XYZ to better grasp the Earnings Per Share calculation:

Suppose company XYZ has a net income of £800,000. It has distributed £100,000 as dividends to preferred stockholders. Furthermore, XYZ company has 350,000 outstanding shares of common stock.

The EPS calculation would consequently be:

With some simple math:

So, the EPS for company XYZ is £2. Consequently, XYZ company has earned £2 per outstanding share of common stock.

Explanation of a Negative Earnings Per Share

A negative Earnings Per Share value, often seen in parentheses (eg. -£1.50 EPS), signifies that the company is incurring losses instead of making profits. This could be due to high costs, economic recession, a downturn in the industry, or poor management. Similarly to profitable scenarios, the higher the absolute value of the negative EPS, the higher the loss per share of common stock. For instance, if a company reports an EPS of -£0.50, it means it has lost 50 pence for every outstanding share over the specific period. A negative EPS isn't an uncommon occurrence, especially for start-ups and companies in growth or transition phases. However, sustained negative EPS over multiple years could be a warning sign for investors, as it could indicate systemic issues within the company. This comprehensive dive into the mathematics behind Earnings Per Share provides a clearer understanding of how EPS is calculated and the insights it can bring. Armed with this knowledge, you're better equipped to interpret EPS as part of your broader analysis when making business decisions.

Analysis of Earnings Per Share

Analysis of Earnings Per Share (EPS) forms an integral part of financial analysis for business analysts, investors, and even management. This mainstay of financial reporting provides great insights into a company's profitability and financial performance. Let’s now delve into more profound aspects of EPS analysis and discover what it reveals.

Performing an Earnings Per Share Ratio Analysis

When performing an analysis of Earnings Per Share, you're primarily focusing on trends in the EPS over time and comparing the EPS with other companies in the same sector. EPS Ratio Analysis or EPS Analysis involves the calculation and assessment of key parameters to provide a comprehensive view of the company’s economic health and stability.

Here are a few important concepts to keep in mind while carrying out an EPS analysis:

• Trends in EPS: Monitoring the EPS over several years gives a reliable glimpse into the company’s trend of profitability. A steady increase in EPS usually indicates that the company is well managed and profitable. However, a declining or fluctuating EPS could be a signal for potential underlying problems.
• Sector Comparison: EPS values should always be compared with other companies within the same sector. This is because different industries have diverse economic structures and scales of operation, which invariably influence EPS.
• EPS Growth: Increasing EPS over time could point to growing profitability, which is a key sign of a strong, successful company. Nevertheless, growth must be sustainable and maintainable to have any real value.
• Dividend Distribution: An impressive EPS should ideally be accompanied by healthy dividends. After all, a high EPS can often lead to a higher dividend payout. If a company is earning well but not distributing proportionate dividends, it could indicate potential financial management issues.

Interpreting the Results: What does Earnings Per Share tell you?

Earnings Per Share is a potent tool to gauge a company's profitability on a per-share basis. But the number alone doesn’t tell the complete story. Interpretation of the EPS figure, context, and trends are equally important. A high EPS can mean that a company is profitable and, potentially, a good investment. However, you should take other factors into account such as the company's price-to-earnings (P/E) ratio, debt levels, future prospects, and overall financial health.

While Earnings Per Share is a significant measurement of a company's profitability, always be sure to use it alongside other financial ratios for a comprehensive inspection.

The Practical Implications of Earnings Per Share Interpretation

Understanding the practical implications of Earnings Per Share interpretation is vital for making informed investment or strategic decisions. A high EPS typically indicates a potentially lucrative company from an investor's perspective because it signifies that a business is capable of generating sizable profits. That’s why companies strive for a high EPS, trying to make their stocks more appealing. On the other hand, a low EPS could signal weak profitability or difficulties ahead.

What to do when faced with Negative Earnings Per Share?

A negative Earnings Per Share can be daunting and raise several red flags. It indicates that the company is not earning profits, rather, it's generating losses. When encountered with a negative EPS, it's crucial to comprehend the underlying reasons. Is it due to increased operating costs, an overall economic downturn, or lack in management efficiency? Is it a one-time situation or a chronic issue?

Keeping its root cause in mind, investors, analysts, and management should devise a strategy accordingly. A one-time negative EPS may not be a severe issue, especially in sectors where companies face cyclical profitability or where firms are still in their start-up phase. Here, the emphasis should be on the management's strategy to navigate the downturn and increase profits in the future.

However, a persistent or chronic negative EPS is a far more ominous sign. It could signify a fundamental issue with the company's business model or management. In such situations, serious considerations about the continuing viability of the enterprise are needed.

Remember, just as with positive EPS, negative EPS should also be compared with other businesses within the industry. A negative EPS during a widespread economic downturn might not be as concerning as it is in a booming economy. And, as always, utilising a combination of financial ratios and tools will yield the most accurate perspective.