What is Earnings Per Share (EPS)?
If you want to invest in stocks, you must first select the right stocks. Selection criteria such as financial ratios are necessary for this. One of the most important values in this context is the EPS (earnings per share) ratio, which can be used to assess a company's earning power.
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What is EPS?
Earnings per share (EPS) is calculated by dividing a company's net income (also known as profits or earnings) with the number of outstanding shares of its common stock. The resulting number is used to determine a company's profitability.
The higher a company's EPS, the more profitable it is thought to be, as it shows how much the market is willing to pay for each dollar of earnings.
A high EPS figure, however, is not always entirely reliable, and its inclusion in the annual financial statements is required by standard international accounting standards (IFRS - International Financial Reporting Standards and US GAAP - United States Generally Accepted Accounting Principles).
What does EPS Indicate?
The EPS rating allows one to draw conclusions about a company's financial situation and profitability. As a result, it is one of the most important tools for stock market investment decisions. The following examples demonstrate the significance of the Earnings Per Share indicator.
- EPS can be used to compare the earnings power of various companies at any given time.
- EPS can also be used to assess a company's financial position over the years. Companies with a steadily rising EPS indicator could prove to be a good investment option. Companies with erratic or declining EPS ratings, on the other hand, are usually avoided by experienced investors.
- A higher EPS means greater profitability, which allows companies to pay out more money in dividends to stockholders.
However, it is also important to consider what the EPS metric does not reveal. For example, cash flow is an important factor in determining a company's ability to repay debt.
However, cash flow, which roughly indicates a company's liquidity, is not taken into account when calculating EPS. This means that even a high EPS doesn't always lead to conclusions about a company's solvency.
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How to Calculate Earnings Per Share?
In theory, calculating earnings per share is straightforward. The following formula is used:
❓ EPS = net income / number of shares outstanding, in each case referring to the same period.
A simple example: Let's assume company X and Y both had sales of 500 million euros last year. If this means company X makes a net income of 100 million euros, but company Y only makes a net income of 50 million euros, your gut reaction would probably be to think that company X's shares are a better buy than company Y's shares. This is where EPS comes into play.
Let's further assume that company X has 50 million shares outstanding, but company Y only has 10 million. Using the EPS formula and assuming that neither company pays dividends, the corresponding earnings per share for company X would be two euros, but for company Y it would be five euros. This changes the appearance of the investment decision.
Another thing to consider: If different dividends are paid for certain classes of shares, such as common and preferred shares, these must be taken into account when calculating earnings per share as follows. A distinction is made between distributed and retained earnings:
❓ EPS by class = retained net income/number of shares per class + dividend per share of class per share of class
✅ EPS for Ordinary Shares
In addition to possible dividend payments, ordinary shares also grant the holder voting rights at the Annual General Meeting of the stock corporation. Preferred shares do not have voting rights, but receive higher dividends as compensation.
However, in order to calculate the EPS of ordinary shares, the additional dividend paid on preferred shares must be deducted. The corresponding formula then looks like this:
❓ EPS ordinary share = net income per ordinary share - dividend for preferred shares / number of ordinary shares.
✅ EPS for Preferred Shares
Preferred shares are attractive to investors who do not care about voting rights. To calculate their EPS, the net profit attributable to the outstanding preferred shares is first determined, to which the (additional) dividend is then added.
❓ EPS preferred share = net income per preferred share + dividend for preferred share / number of preferred shares.
As is readily apparent from the formulas, the level of EPS depends to a large extent on the number of shares outstanding. If a company were to issue new shares, for example because it is planning a capital increase, the arithmetical earnings per share would be significantly reduced. EPS would be "diluted", so to speak.
In these cases, the key figure for investors is therefore the so-called diluted earnings. The EPS calculated in this way shows how much lower the profit would be if new shares were actually issued.
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EPS in Fundamental Analysis
For many purposes, a company's earnings are sufficient as a measure of success. But for you as a stock investor, more in-depth fundamental analysis metrics like earnings per share can be much more important.
These are some factors to consider when conducting a fundamental analysis:
- What are the company's revenues?
- Is there growth being experienced?
- Are profits being generated?
- How significant is the company's debt? Are debts being repaid?
- What is the employee turnover rate?
- Does management care about employees?
Calculating earnings per share is only a starting point for a comprehensive fundamental analysis strategy. However, it is an important part because other fundamental metrics are derived from it.
There are three different types of EPS numbers used, which differ according to the source of the data from which they are calculated:
- Trailing or lagging EPS: Uses the previous year's figures and is considered the actual EPS.
- Current EPS: Uses the current year's figures, but is a projection.
- Forward or projected EPS: Estimated EPS figures for subsequent years based on the current trend.
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What does a Negative EPS mean?
Of course, companies do not always generate a profit. When losses are accrued, EPS is also negative. A negative EPS tells you exactly how much money the company lost per outstanding share, which is why it can also be called a "net loss per share."
However, don’t take a negative EPS at face value.
Biotech companies, for example, frequently lose money for years while developing commercially viable products. Startups, on the other hand, frequently require time to increase sales and profitability. It's a good sign if such a company is gradually reducing its losses and moving toward a positive EPS indicator.
Similarly, established companies face significant one-time expenses, such as write-offs on key investments. If this causes their profits to slip into the red for a quarter or more and the EPS becomes negative, this still doesn't have to mean a grim future in the long term.
So, if a negative EPS is an anomaly rather than a recurring trend, there is no need to panic.
How to Interpret the EPS Value Correctly
As one can see, a company's EPS value is not always reliable. There is sometimes a gap in interpretation that must be filled. Lastly, here are two fundamental guidelines to follow.
❗ Don't compare incomparables: If you want to evaluate a company relative to others, you should pay attention to comparability. For example, you typically look at the EPS of companies in the same industry to get a sense of how they compare to the competition.
Also, make sure that you use EPS values calculated in an identical way (see section How to calculate EPS). This will help you avoid comparing common and preferred stock, for example.
❗ Don't just rely on snapshots: It is best to look at the EPS performance of stocks over time. That way, investors can get a better idea of how profitable a company has been in the past and develop a sense of its future prospects. A company with steadily rising EPS may be considered a more reliable investment than one whose EPS is declining or fluctuating wildly.
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