How To Calculate Eps

Introduction: Understanding and Calculating Earnings Per Share (EPS)

As a DIY investor, understanding the financial health of a company is crucial for making informed investment decisions. One of the key metrics to evaluate a company's profitability is Earnings Per Share (EPS). EPS essentially tells you how much profit a company has generated for each outstanding share of its stock. It's a fundamental indicator used by analysts and investors alike to assess a company's performance, compare it to its competitors, and determine its intrinsic value.

Why is calculating EPS important?

• Profitability Assessment: EPS directly reflects the company's profitability on a per-share basis. A higher EPS generally indicates a more profitable company.
• Comparison Tool: You can compare the EPS of similar companies within the same industry to gauge their relative performance.
• Trend Analysis: Tracking a company's EPS over time helps identify growth trends and potential issues. A consistently increasing EPS suggests strong performance, while a declining EPS might raise concerns.
• Valuation Metric: EPS is a key component in valuation ratios like the Price-to-Earnings (P/E) ratio, which helps determine if a stock is overvalued or undervalued.
• Investment Decisions: Ultimately, EPS informs your investment decisions by providing insights into a company's financial strength and future potential.

Prerequisites: What You Need Before Starting

Before you can calculate EPS, you'll need to gather the following information from the company's financial statements, which are typically available on their investor relations website or through financial data providers:

1. Net Income (or Net Profit): This is the company's profit after all expenses, taxes, and other deductions have been subtracted from revenue. You'll find this figure on the company's income statement.
2. Preferred Dividends (if any): If the company has issued preferred stock, you'll need the amount of dividends paid to preferred shareholders. This is because EPS focuses on earnings available to common shareholders. Look for this information in the income statement or statement of retained earnings.
3. Weighted Average Number of Common Shares Outstanding: This represents the average number of common shares outstanding during the reporting period. It accounts for shares issued or repurchased during the year. You can typically find this figure directly on the income statement, or in the notes to the financial statements. If it's not readily available, you'll need to calculate it (explained in the step-by-step guide).

Step-by-Step Instructions: Calculating Earnings Per Share (EPS)

There are two main types of EPS: Basic EPS and Diluted EPS. Basic EPS is the simpler calculation and focuses solely on the existing common shares. Diluted EPS, which is more comprehensive, considers the potential dilution of earnings from convertible securities, stock options, and warrants. We will cover both.

1. Calculating Basic EPS:

1. Identify Net Income: Obtain the company's net income from the income statement. For example, let's say the company's net income is $10 million.

2. Subtract Preferred Dividends (if any): If the company paid preferred dividends, subtract them from the net income. Let's assume the company paid $1 million in preferred dividends. Therefore, the earnings available to common shareholders are $10 million - $1 million = $9 million. If the company didn't pay any preferred dividends, you can skip this step.

3. Determine the Weighted Average Number of Common Shares Outstanding: Find this number on the income statement or in the notes to the financial statements. Let's say the company had a weighted average of 5 million common shares outstanding. If this number isn't provided, you'll need to calculate it:

   • Start with beginning shares outstanding: Note the number of common shares outstanding at the beginning of the reporting period.
   • Track share issuances and repurchases: Throughout the year, the company may issue new shares (increasing shares outstanding) or repurchase shares (decreasing shares outstanding). Record the number of shares issued or repurchased and the date of each transaction.
   • Calculate the weighted average: For each issuance or repurchase, multiply the number of shares by the fraction of the year they were outstanding. For example, if 1 million shares were issued on July 1st, they would be outstanding for 6 months (or 0.5 of a year). The weighted value would be 1 million * 0.5 = 500,000.
   • Sum the weighted values: Add up all the weighted values for issuances and repurchases to the beginning shares outstanding. This will give you the weighted average number of common shares outstanding.

4. Calculate Basic EPS: Divide the earnings available to common shareholders (calculated in step 2) by the weighted average number of common shares outstanding (calculated in step 3).

   • Basic EPS = $9 million / 5 million shares = $1.80 per share.

2. Calculating Diluted EPS:

Diluted EPS is a more conservative measure of EPS because it considers the potential dilution of earnings if all dilutive securities (like stock options, warrants, and convertible bonds) were exercised or converted into common stock.

1. Start with Basic EPS Calculation: Follow steps 1-4 of the Basic EPS calculation to determine the earnings available to common shareholders and the weighted average number of common shares outstanding before considering dilution.

2. Identify Potential Dilutive Securities: Review the company's financial statements and notes to identify any securities that could potentially dilute earnings. These typically include:

   • Stock Options and Warrants: These give the holder the right to purchase common stock at a specific price.
   • Convertible Bonds: These are bonds that can be converted into a specific number of common shares.
   • Convertible Preferred Stock: Similar to convertible bonds, these preferred shares can be converted into common stock.

3. Determine the Dilutive Effect of Each Security:

   • Stock Options and Warrants (Treasury Stock Method): This method assumes that the company uses the proceeds from the exercise of options and warrants to repurchase shares of its own stock at the average market price during the period.
     • Calculate the number of shares that would be issued if all options and warrants were exercised.
     • Calculate the proceeds from the exercise (number of options/warrants * exercise price).
     • Determine the number of shares that could be repurchased with those proceeds (proceeds / average market price).
     • Calculate the incremental shares added to the denominator: (Shares issued from option exercise) - (Shares repurchased using proceeds).
     • If the exercise price is higher than the average market price, the options/warrants are anti-dilutive and should not be included in the diluted EPS calculation.
   • Convertible Bonds and Convertible Preferred Stock (If-Converted Method): This method assumes that the convertible securities were converted at the beginning of the period (or at the time of issuance, if later).
     • Add back the after-tax interest expense (for convertible bonds) or preferred dividends (for convertible preferred stock) to the net income (numerator). The after-tax adjustment is calculated as: Interest Expense * (1 - Tax Rate).
     • Add the number of shares that would be issued upon conversion to the weighted average number of common shares outstanding (denominator).
     • If the effect of converting is anti-dilutive (i.e., increases EPS), do not include it in the diluted EPS calculation.

4. Calculate Diluted EPS:

   • Adjust the numerator (earnings available to common shareholders) by adding back the after-tax interest expense or preferred dividends from convertible securities.

   • Adjust the denominator (weighted average number of common shares outstanding) by adding the incremental shares from options/warrants and the shares that would be issued upon conversion of convertible securities.

   • Divide the adjusted numerator by the adjusted denominator.

   • Diluted EPS = (Adjusted Net Income) / (Adjusted Weighted Average Shares Outstanding)

5. Present Both Basic and Diluted EPS: Companies are required to present both Basic and Diluted EPS on the face of their income statement.

Common Mistakes: What to Avoid

• Incorrectly Calculating Weighted Average Shares: Accurately tracking and weighting share issuances and repurchases is crucial. A simple average will not suffice.
• Ignoring Preferred Dividends: Failing to subtract preferred dividends from net income will overstate earnings available to common shareholders.
• Misidentifying Dilutive Securities: Not all securities are dilutive. Understanding the criteria for determining dilutive effects is essential.
• Arithmetic Errors: Simple calculation errors can significantly impact the accuracy of EPS. Double-check your work.
• Using the Wrong Time Period: Ensure you're using data from the correct reporting period (e.g., annual vs. quarterly).
• Forgetting the After-Tax Effect: When using the if-converted method, remember to adjust the numerator (net income) by the after-tax effect of adding back interest expense.
• Including Anti-Dilutive Securities: It's crucial to exclude anti-dilutive securities from the diluted EPS calculation, as they would falsely inflate the EPS figure.

Expert Tips: Best Practices

• Use a Spreadsheet: Employ a spreadsheet program (like Excel or Google Sheets) to organize your data and perform calculations. This will help prevent errors and make it easier to update your analysis.
• Review Management's Discussion and Analysis (MD&A): The MD&A section of the company's annual report often provides insights into factors affecting EPS and any significant changes in share count.
• Compare to Industry Peers: Don't just look at a company's EPS in isolation. Compare it to the EPS of its competitors to get a sense of its relative performance.
• Track EPS Trends Over Time: Monitor a company's EPS over several years to identify trends and assess its long-term profitability.
• Understand the Impact of Accounting Changes: Be aware of any changes in accounting standards that could affect EPS comparability over time.
• Focus on Quality of Earnings: While EPS is important, consider the quality of those earnings. Are they sustainable and derived from core business operations, or are they the result of one-time gains?
• Consider Other Metrics: EPS is just one piece of the puzzle. Use it in conjunction with other financial metrics to get a complete picture of a company's financial health.
• Stay Updated: Keep up with the latest accounting standards and regulations that may affect EPS calculations.

Summary: Wrapping Up

Calculating EPS is a fundamental skill for any DIY investor. By understanding the steps involved in calculating both Basic and Diluted EPS, avoiding common mistakes, and following best practices, you can gain valuable insights into a company's profitability and make more informed investment decisions. Remember that EPS is just one metric to consider, and it should be used in conjunction with other financial analysis tools to assess a company's overall financial health and investment potential. Good luck!