EPS is a carefully scrutinized metric that is often used as a barometer to gauge a company's profitability per unit of shareholder ownership. As such, earnings per share is a key driver of share prices. It is also used as the denominator in the frequently cited P/E ratio.
EPS can be calculated via two different methods: basic and fully diluted. Fully diluted EPS -- which factors in the potentially dilutive effects of warrants, stock options and securities convertible into common stock -- is generally viewed as a more accurate measure and is more commonly cited.
EPS can be subdivided further according to the time period involved. Profitability can be assessed by prior (trailing) earnings, recent (current) earnings or projected future (forward) earnings. Though earning per share is widely considered to be the most popular method of quantifying a firm's profitability, it's important to remember that earnings themselves can often be susceptible to manipulation, accounting changes and restatements. For that reason, free cash flow is seen by some to be a more reliable indicator than EPS. Nevertheless, earnings per share remains the industry standard in determining corporate profitability for shareholders.
What Does EPS Stand For in the Stock Market?
Understanding Basic EPS and Diluted EPS
If you pick up a newspaper, read a financial magazine, or watch the financial news, you are likely to hear the phrase EPS when discussing how profitable a company is. What is EPS? What does EPS stand for and why should you care? You'll discover in a moment that the answer is some of the most important things in the world to any investor worth his or her salt.
The Definition of EPS
Simply put, EPS is an acronym that stands for Earnings Per Share.
In effect, there are two types of EPS figures that investors are likely to encounter when they study a company's income statement by picking up the annual report or Form 10-K: Basic EPS and Diluted EPS. Both tell the investor or potential investor different things.
- Basic EPS - A company's Basic EPS, or Basic Earnings Per Share, is the figure that results when a business takes the profit it earned over a certain period, perhaps a quarter or a year, and divides it by the average number of shares of stock the company had issued and outstanding. If the company earned $500 million and had 250 million shares of stock issued and outstanding, Basic EPS would be $2.00 because $500 million profit divided by 250 million shares = $2.00
- Diluted EPS - A company's Diluted EPS is the same thing except the shares outstanding figure is adjusted to include shares that might or will be issued in the future, such as those connected with employer stock options, convertible preferred stock, warrants, or other dilutive securities. If a company has a significant amount of potential dilution lurking in the books, the "real" EPS figure would be lower than the basic EPS figure in profitable years because the net income would need to be split by more shares. Personally, in my own analysis as well as the analysis at the asset management company through which I will be managing my own family's wealth as well as the wealth of affluent and high net worth clients who invest alongside us, Kennon-Green & Co., I'm far more interested in Diluted EPS. I think Basic EPS isn't worth nearly as much in comparison absent certain special circumstances such as a high conviction that the dilution won't come to pass for one reason or another. (In actuality, what I prefer to use isn't EPS at all, but rather a modified free cash flow figure known as Owner Earnings.)
The Reason Basic EPS and Diluted EPS Figures Are Important to New Investors
Why is EPS so important? Many conservative investors use Basic EPS and Diluted EPS to calculate how much they think a stock is worth. Specifically, EPS forms the basis of several important financial ratios including:
- The Price-to-Earnings Ratio or P/E Ratio - The p/e ratio of a stock tells you how many years it would take a company's basic EPS to pay you back your investment cost assuming no taxes were owed on distributions, there was no growth, and all earnings were paid out as cash dividends. The p/e ratio can be inverted to calculate the earnings yield.
- The PEG Ratio - The price-to-earnings growth ratio, or PEG ratio, is a modified form of the p/e ratio that takes basic EPS and then calculates the p/e ratio with an adjustment for the projected growth in earnings per share over the coming years. To learn more about this, read Using the PEG Ratio to Uncover Hidden Stock Gems.
- The Dividend-Adjusted PEG Ratio - Going one step further, the dividend-adjusted price-to-earnings growth ratio, or dividend adjusted PEG ratio, is a modified form of the PEG ratio that takes the basic EPS figure and then takes into account the valuation not only for the expected growth in future earnings per share but also the dividend yield, as well. To learn more about this, read The Dividend-Adjusted PEG Ratio Can Help You Find Undervalued Blue Chip Stocks.
Figuring out which multiple to EPS to pay for a company can be tricky. Some investors set hard and fast rules, which aren't necessarily intelligent as they don't factor in inflation, taxes, and risk, such as only paying 10x earnings for a stock. Other people pay 8.5x EPS + the expected rate of growth in EPS, which was a formula highlighted by legendary value investor Benjamin Graham. That is, if a company were growing at 15%, Graham said you probably shouldn't pay more than 8.5x + 15 = 23.5x diluted EPS.
For a company earning $2.00 EPS, that would be $47 per share because 23.5 x $2.00 = $47.
Basic EPS and Diluted EPS are also important because dividends are ordinarily paid out of profits. If a company has EPS of $2.00, it can't pay dividends of $3.00 indefinitely. It's just not possible. Dividend investors look at the percentage of EPS paid out as dividends to gauge how "safe" a company's dividend payment is. For more information on this topic, read What Is Dividend Investing?.
For a much more advanced discussion, read my essay on Basic EPS vs. Diluted EPS, which are part of the Investing Lessons explaining how to read financial statements.