TheStreet

Earnings per share measures how much net, after-tax income the company has made per share of common stock. It is one of the most common ways of reporting a company's profitability.

For investors it is a critical metric of corporate health.

What Are Earnings Per Share?

For a publicly owned company, each shareholder has a stake in the company's quarterly profits. Earnings per share (EPS) measures this. It reports how much net income a company has earned per share of common stock.

A company will typically report EPS either quarterly or annually.

How Are Earnings Per Share Calculated?

As noted above, a company's earnings per share is how much net, after-tax income the company has per share of common stock. Put another way, it is the company's profitability after paying dividends on any preferred stock. (Note that net income typically includes tax payments.)

This formula can be expressed as:

EPS = (Net Income - Preferred Dividends) / Average Shares of Common Stock

Each of those items breaks down into a little bit more detail.

Net Income After Taxes

From our dictionary definition on the subject, "net income (sometimes abbreviated as NI) stands for a company's or an individual's total earnings after taxes, direct costs, depreciation, interest, amortization, and other expenses."

This is what people commonly think of as a company's profit margin, the total amount of money after earnings and expenses. After a company has made and spent all of its money for the year net income is what's left.

Preferred Dividends

Here's where earnings per share can get a little bit tricky.

Many larger public companies will have multiple classes of stock, including issuing what are called "preferred shares." These will typically have different voting rights than shares of common stock and be unavailable for general purchase on listed stock exchanges.

Relevant to the purposes of calculating EPS, preferred shares claim any dividends before common stock. They often pay a guaranteed dividend, as opposed to common stock which pays a discretionary dividend, and as such in some ways can be considered debt instruments.

Since preferred shares have priority over common shares, their dividends are not considered part of the common stockholder's earnings. This is why it is deducted from the company's net income before calculating EPS.

Average Shares of Common Stock

Common stock is generally available for purchase on a listed exchange. It comes with voting rights and will typically pay dividends at the discretion of the company's board of directors.

In calculating the shares of common stock a company should use its average number of shares outstanding for the relevant period. For an annual EPS calculation, then, a company would use its average number of outstanding shares over the past year.

Sometimes analysts simply use the current number of outstanding shares of common stock. This is typically considered less accurate, but may be appropriate in some edge cases. For example, if a company released new shares effective as of one day into the accounting period, it might be more accurate to disregard the previous number of outstanding shares.

Finally, in an effort toward greater precision, some analysts will use a weighted average of outstanding shares. In this case, average the number of shares based on which percentage of the accounting period each total number of shares occupied. We will demonstrate this method below.

Example of Earnings Per Share Calculation

Mystery Co. is calculating its annual earnings per share report. To do so, it would run the following formula:

• Net Income After Taxes: $100 million

Mystery Co. had $280 million in revenue this year. It spent $100 million on salaries, debt, costs of goods and all other operational expenses. It paid another $80 million in taxes. Its net income after taxes, then is $100 million.

• Preferred Dividends: $2 million

Mystery Co. pays 2% of net profits to its preferred shareholders as a preferred dividend. Its preferred dividends, then, amount to $2 million.

• Average Shares of Common Stock: 11.25 million

In the first half of the year, Mystery Co. had 10 million shares of common stock outstanding. At the end of the third quarter it released 5 million more shares, bringing its total shares of outstanding common stock to 15 million.

Our weighted average of common shares, then, is: (.75 x 10 million) + (.25 X 15 million) = 11.25 million.

The earnings per share for Mystery Co. over the past year is calculated as follows:

• EPS = ($100 million - $2 million) / 11.25 million

• EPS = $98 million / 11.25 million

• EPS = $8.71 per share

Mystery Co. has made $8.71 in net income per share of outstanding common stock.

Earnings Per Share Does Not Mean Personal Profit

Earnings per share does not mean actual profit accruing to individual investors.

While this does measure the amount of profit the company has made per share of stock, the board of directors decides how much (if any) to distribute among individual shareholders. Many stocks will not pay a dividend at all, meaning that the company has chosen to retain all of its earnings per share.

Even in the case where a company does pay dividends, those will only be a fraction of the earnings reported per share.

How to Read Earnings Per Share

Earnings per share can tell you several possible things about a company. These include:

1. The Chance of Dividend Payments

While we note above that a healthy EPS does not guarantee that common stockholders will receive a dividend, the two are still connected. High earnings per share means that the company has a lot more money per shareholder which can signal the potential for dividend payments to come.

2. Potential for Growth and Reinvestment

A strong EPS measure can also mean that the company is well positioned to grow. If profits are strong it may signify extra capital that the company can reinvest. This is a good indicator for corporate health and further profits to come.

3. The Price-to-Earnings Ratio

Finally, earnings per share is an essential part of the widely used price to earnings ratio, otherwise known as the P/E Ratio. In fact, EPS is the "E" in P/E. In this formula, "P" represents the company's share price on the market.

The P/E Ratio compares a company's stock price to its per-share earnings. For example, if a company's current stock price is $10 and its EPS is $2, then that company's P/E Ratio is 5. Investors are willing to spend $5 to buy $1 worth of that company's earnings per share.

A full analysis of the P/E Ratio is outside the scope of this article, but it is a powerful tool and the EPS is an essential element of it.

Limits of Earnings Per Share

Like all market metrics, the EPS has its limits.

• Per share data doesn't tell you how efficiently the company spends its money.

While earnings per share gives you a sense of an investor's relationship to the company's profits, this doesn't tell you much about corporate performance. Low earnings per share, for example, might only mean that the company has spent a lot of money on growth in the past year. High earnings per share might mean that the company has a lot of capital for its size, but that doesn't necessarily mean it will spend that money wisely.

Earnings per share tells you something about how much capital the company has. It doesn't tell you why or what it will do with that money.

• The number of shares does not necessarily correlate with corporate size.

Let's say a company posted an earnings per share of $100. This would look outstanding, better than virtually any competitor.

It would look considerably less rosy if this nation-wide firm had only issued 10 shares of stock. In that case, our extraordinary EPS would mask the fact that the company only held about $1,000 in profits from the past year.

The number of outstanding shares does not necessarily correlate to a company's size, total profits or needs. While a strong EPS can indicate a well-capitalized firm, it's important to make sure that it doesn't actually mean a firm that simply bought back enough of its stock to lower the denominator in the EPS formula.

Special Cases With Earnings Per Share

Finally, there are a few unusual and special cases that can arise when calculating earnings per share.

1. Trailing vs. Forward EPS

At times, particularly when calculating the P/E Ratio, firms will distinguish between a trailing EPS and a Forward EPS (also called the Expected EPS).

Trailing EPS is the standard formula. This means that the formula uses earnings data from the past. For example in an annual report a trailing EPS would use earnings from the past 12 months. Forward EPS uses anticipated earnings. It makes an estimate at the firm's probable net income in the coming accounting period and calculates earnings per share based on that.

2. Diluted EPS

The Diluted EPS includes not only all currently outstanding shares of common stock but also all convertible options for common stock when calculating the earnings per share.

For some companies, their existing shares of common stock are not the only possible shares distributed. They will also issue what are called "convertible securities." These are assets that can become shares of common stock. Some executive stock options, for example, might convert into shares of common stock when exercised. In this case the total number of outstanding shares would increase.

Diluted EPS uses the total number of extant and possible shares of common stock when calculating earnings per share.

3. EPS Adjusted for Extraordinary Items

Finally, some companies will discount what are called "extraordinary items" from the earnings per share report.

An extraordinary item is a one-time gain or loss that the company does not think will realistically be repeated. It is typically something which happens outside the ordinary course of business.

For example, a firm which finds buried treasure worth $10 million on the site of its new store may choose not to include that windfall in its earnings report. This is a one-time event not related to the company's business, and as a result investors might be misled if they thought that it represented the potential for future profits.