Earnings per share (EPS) is one of the most widely used financial metrics in the world of investing. Learning about EPS is necessary for evaluating companies and helping your clients make good investment choices.
In this article, Wealth Professional Canada will discuss how EPS is calculated and why it matters. We’ll also talk about what makes a good EPS and why you need to use it with other metrics.
Earnings per share is a financial metric that tells you how much profit a company makes for each share of its stock. It is a simple but powerful way to measure a company’s profitability on a per-share basis. When you look at EPS, you want to check how much of the company’s profit is available to each shareholder.
You can use our free EPS calculator below:
EPS is especially useful for comparing companies within the same industry or tracking a company’s performance over time. A higher EPS generally means that a company is more profitable, which can make it more attractive to investors and your clients.
EPS should never be used in isolation. It is important to consider other financial metrics and the company’s overall situation before making recommendations to your clients.
Watch this video to learn more about EPS:
EPS can also be used when conducting fundamental analysis. Combining this measure with other ratios and metrics is helpful in pinpointing companies that are worth investing in.
For financial advisors, EPS is a vital measure for evaluating stocks and building portfolios for your clients. This can help you:
EPS is also a key component in other essential financial ratios, such as the price-to-earnings (P/E) ratio. This is because you need to divide the current share price by the EPS to get the P/E ratio.
When you’re knowledgeable about how EPS works, you can better interpret these ratios and provide more comprehensive advice to your clients.
Calculating EPS is straightforward, but it is necessary to understand the details. The basic formula for EPS is:
Let’s break down each part of the formula:
This is the company’s total profit after all expenses, taxes, and costs have been deducted from revenue.
If the company has issued preferred shares, any dividends paid to those shareholders are subtracted from net income. This is because EPS is meant to show the profit available to common shareholders.
This is the average number of common shares the company had in circulation during the reporting period. It accounts for any changes in the number of shares due to buybacks or stock splits.
Here's a sample scenario where we’ll use the formula above to get the EPS:
Suppose a company has a net income of $12 million, pays $2 million in preferred dividends, and has five million common shares outstanding. The EPS would be $2 per share.
This means that for every share your clients own, the company generated $2 in profit during the reporting period.
A good EPS is often one that is growing steadily over time. If a company’s EPS increases year after year, it might indicate that the company is becoming more profitable and managing its resources well. This can be a positive sign for your clients, especially those who are looking for stable investments.
However, it is also important to compare a company’s EPS to that of its competitors. For example, if two companies operate in the same industry, the one with the higher EPS might be more attractive, all else being equal.
But even such comparison has its limits. Sometimes, a company’s EPS might go up, but not as much as investors expected. In such cases, the company’s stock price might still fall, even though its EPS improved.
Financial advisors should also consider the price-to-earnings (P/E) ratio, which compares a company’s stock price to its EPS. A lower P/E ratio can indicate that a stock is undervalued, while a higher P/E ratio might suggest it is overvalued. But again, these numbers must be interpreted in the context of the company’s industry, growth prospects, and the overall market environment.
In summary, a good EPS:
Still, it is just one piece of the puzzle. There is no universal number that qualifies as a good or bad EPS. Instead, the value of EPS must be considered in context.
To help you explain EPS to your clients, here are some usual scenarios that can affect EPS:
You must help investors understand that changes in EPS can result from many factors, not just changes in the company’s actual profitability.
EPS and return on equity (ROE) are both important metrics for financial advisors, but they measure different things.
While EPS tells you how much profit is available to each shareholder, ROE tells you how well the company is using the money invested by shareholders to generate earnings. Both metrics are useful, but they answer different questions.
EPS is particularly helpful when comparing companies in the same industry or tracking a company’s performance over time. On the other hand, ROE is useful for assessing how effectively a company is using its capital. Using both metrics together can give you a more complete understanding of a company’s financial health.
There are two main types of EPS:
Diluted EPS is usually lower than basic EPS because it assumes more shares could be added to the market. This would also reduce the profit available per share.
Let’s say that the company in our earlier example had employee stock options. It also has convertible debt that could be turned into two million additional shares. Using the formula, the diluted EPS would be $1.43 per share.
Diluted EPS gives a more conservative view of a company’s profitability. This is especially helpful for financial advisors who want to understand the full picture before making any recommendations to their clients. Watch this video to learn more:
Aside from ROE and the other financial metrics mentioned, you might also want to look at the price-to-book (P/B) ratio and the price-to-sales (P/S) ratio. These measures can enhance your strategies, especially when recommending the best stock picks to investors.
While EPS is a valuable metric, it is not without flaws. Here are some of its limitations:
Companies can increase EPS by buying back shares or decrease it by issuing new shares or splitting stocks. These actions do not always reflect real changes in profitability.
Sometimes, changes in accounting policies can alter EPS without any real change in the company’s financial health.
A high or low EPS does not tell you whether a stock is overvalued or undervalued. It must be considered alongside the company’s share price and other metrics.
EPS is based on net profit, which can be influenced by non-operating expenses, taxes, and accounting choices. It does not account for other vital elements for assessing a company’s health, such as cash flow or debt.
Because of these limitations, you must use EPS in combination with other financial metrics and qualitative factors when advising your clients.
Earnings per share is a fundamental metric that every financial advisor should understand and use. It’s a simple but beneficial way to measure a company’s profitability on a per-share basis. This makes it an impactful element in many investment decisions.
Still, EPS is just one measure. Always consider it alongside other metrics and qualitative information to get a complete picture of a company’s financial health. By doing so, you can help your clients achieve their investment goals and build stronger, more resilient portfolios.
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