What it means
EPS takes the profit left for ordinary shareholders after tax, interest and any preferred dividends, then divides it by the average number of ordinary shares in issue during the year. The result is a per share figure, usually quoted to two decimal places, that lets you compare a company with its own past performance and with rivals of very different sizes.
The reason it dominates financial reporting is comparability. A profit of $48 million tells you nothing on its own, because a company that doubled its share count to earn that profit has watered down every existing owner.
EPS strips out the effect of company size and share issuance in a single number. Listed companies report two versions of it.
Basic EPS uses the shares actually in issue, while diluted EPS assumes every share option, convertible bond and warrant turns into real shares, which pushes the figure down. Analysts usually work with the diluted number because it shows the realistic worst case for someone already holding shares.
The share count is a weighted average rather than a year end snapshot, because shares issued in November only shared in two months of profit. Many companies also strip out one off items to publish an adjusted or underlying EPS, which is a management judgement rather than a rule set by accounting standards.
Because bonuses and share prices often ride on this number, it can be managed. A large share buyback shrinks the denominator and lifts EPS without the business earning a single extra dollar, so it is always worth checking whether growth came from real profit or from a smaller share count.
In practice
Real-world examples.
Example
A software company posts flat profit of $20,000,000 but buys back 10% of its shares during the year. EPS rises from $2.00 to about $2.22 even though the business earned no extra money, and the chief financial officer is careful to explain that split in the results presentation.
Example
A supermarket chain issues 40,000,000 new shares in September to fund a distribution centre. Because the shares only existed for four months of the financial year, the weighted average count rises by roughly 13,000,000 rather than the full 40,000,000, softening the hit to reported EPS.
Example
An investor comparing two industrial manufacturers finds one earning $180,000,000 and the other $60,000,000, and assumes the larger is the better buy. Once she divides by share counts she finds EPS of $1.20 and $3.00, and the smaller company is generating far more profit per share owned.
Think of it
“EPS shows profit per share-what each share earned.
Formula
Calculation
Basic EPS = (Net profit after tax - preferred dividends) / weighted average number of ordinary shares
Take a listed engineering group that reports net profit after tax of $48,000,000 and pays $3,000,000 of dividends to holders of preferred shares. The profit attributable to ordinary shareholders is $48,000,000 - $3,000,000 = $45,000,000. With a weighted average of 15,000,000 ordinary shares in issue, basic EPS = $45,000,000 / 15,000,000 = $3.00 per share.
Now assume outstanding share options and convertible bonds would add another 3,000,000 shares if exercised, taking the diluted count to 18,000,000. Diluted EPS = $45,000,000 / 18,000,000 = $2.50 per share, which is 50 cents lower. If the shares trade at $36.00, the price to earnings ratio on the basic figure is $36.00 / $3.00 = 12 times, and on the diluted figure it is $36.00 / $2.50 = 14.4 times.Case study
Seen in the real world.
This is an illustrative and entirely fictional example. Harbourline Instruments, an invented maker of laboratory equipment, had promised the market three straight years of double digit EPS growth, and its executive bonus scheme paid out only if that promise was kept. In the third year underlying trading was soft, with operating profit up just 2%.
Rather than miss the target, the board approved a $90,000,000 buyback funded by new bank borrowing, which retired about 8% of the shares in issue. Reported EPS duly rose 11%, the bonuses were paid, and the press release led with the growth figure without dwelling on where it came from.
Two years later the additional interest cost bit into profit just as demand weakened, and Harbourline's fictional finance team had to cut the dividend. The episode is a reminder that EPS can be engineered from the denominator, and that a reader who never checks the share count will not spot it.
Watch out
Common mistakes.
- Comparing EPS between two companies as though it were a measure of quality, when a business can simply have fewer shares in issue and a higher figure as a result.
- Using the year end share count instead of the weighted average, which distorts the figure badly in any year with a large share issue.
- Quoting adjusted EPS without noting what was excluded, since the adjustments are chosen by management and are not governed by accounting standards.
Questions
People also ask.
Why is diluted EPS always lower than basic EPS?
Because it spreads the same profit over a larger assumed share count, so the only time the two match is when a company has no options, warrants or convertibles outstanding.
Does EPS tell you anything about cash?
Very little, because profit includes non cash charges such as depreciation and can be earned long before customers actually pay.
Is a falling EPS always bad news?
Not necessarily, as it can reflect shares issued to fund an acquisition or expansion that will raise profit in later years.
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