15. Basic Earnings Per Share (EPS)¶
15.1. What is Basic Earnings Per Share?¶
Basic earnings per share (EPS) tells investors how much of a firm’s net income was allotted to each share of common stock. It is reported in a company’s income statement and is especially informative for businesses with only common stock in their capital structures.
15.2. Understanding Basic Earnings Per Share¶
One of the first performance measures to check when analyzing a company’s financial health is its ability to turn a profit. Earnings per share (EPS) is the industry standard that investors rely on to see how well a company has done.
Basic earnings per share is a rough measurement of the amount of a company’s profit that can be allocated to one share of its common stock. Businesses with simple capital structures, where only common stock has been issued, need only release this ratio to reveal their profitability. Basic earnings per share does not factor in the dilutive effects of convertible securities.
Basic EPS = (Net income - preferred dividends) ÷ weighted average of common shares outstanding during the period.
Net income can be further broken down into ‘continuing operations’ P&L and ‘total P&L’ and preferred dividends should be removed as this income is not available to common stockholders.
If a company has a complex capital structure where the need to issue additional shares might arise then diluted EPS is considered to be a more precise metric than basic EPS. Diluted EPS takes into account all of the outstanding dilutive securities that could potentially be exercised (such as stock options and convertible preferred stock) and shows how such an action would affect earnings per share.
Companies with a complex capital structure must report both basic EPS and diluted EPS to provide a more accurate picture of their earnings. The main difference between basic EPS and diluted EPS is that the latter factors in the assumption that all convertible securities will be exercised. As such, basic EPS will always be the higher of the two since the denominator will always be bigger for the diluted EPS calculation.
Basic earnings per share (EPS) tells investors how much of a firm’s net income was allotted to each share of common stock. Businesses with simple capital structures, where only common stock has been issued, need only release this ratio to reveal their profitability. Companies with a complex capital structure must report both basic EPS and diluted EPS to provide a more accurate picture of their earnings.
15.3. Basic Earnings Per Share Example¶
A company reports net income of $100 million after expenses and taxes. The company issues preferred dividends to its preferred stockholders of $23 million, leaving earnings available to common shareholders of $77 million. The company had 100 million common shares outstanding at the beginning of the year and issued 20 million new common shares in the second half of the year. As a result, the weighted average number of common shares outstanding is 110 million: 100 million shares for the first half of the year and 120 million shares for the second half of the year (100 x 0.5) + (120 x 0.5) = 110. Dividing the earnings available to common shareholders of $77 million by the weighted average number of common shares outstanding of 110 million gives a basic EPS of $0.70.
15.4. Impact of Basic Earnings Per Share¶
Stocks trade on multiples of earnings per share, so a rise in basic EPS can cause a stock’s price to appreciate in line with the company’s increasing earnings on a per share basis.
Increasing basic EPS, however, does not mean the company is generating greater earnings on a gross basis. Companies can repurchase shares, decreasing their share count as a result and spread net income less preferred dividends over fewer common shares. Basic EPS could increase even if absolute earnings decrease with a falling common share count.
Another consideration for basic EPS is its deviation from diluted EPS. If the two EPS measures are increasingly different, it may show that there is a high potential for current common shareholders to be diluted in the future.
15.5. 1. Working Capital Ratio¶
Assessing the health of a company in which you want to invest involves understanding its liquidity—how easily that company can turn assets into cash to pay short-term obligations. The working capital ratio is calculated by dividing current assets by current liabilities.
So, if XYZ Corp. has current assets of $8 million, and current liabilities of $4 million, that’s a 2:1 ratio—pretty sound. But if two similar companies each had 2:1 ratios, but one had more cash among its current assets, that firm would be better able to pay off its debts quicker than the other.
15.6. 2. Quick Ratio¶
Also called the acid test, this ratio subtracts inventories from current assets, before dividing that figure into liabilities. The idea is to show how well current liabilities are covered by cash and by items with a ready cash value. Inventory, on the other hand, takes time to sell and convert into liquid assets. If XYZ has $8 million in current assets minus $2 million in inventories over $4 million in current liabilities, that’s a 1.5:1 ratio. Companies like to have at least a 1:1 ratio here, but firms with less than that may be okay because it means they turn their inventories over quickly.
15.7. 3. Earnings per Share¶
When buying a stock, you participate in the future earnings (or risk of loss) of the company. Earnings per share (EPS) measures net income earned on each share of a company’s common stock. The company’s analysts divide its net income by the weighted average number of common shares outstanding during the year.
15.8. 4. Price-Earnings Ratio¶
Called P/E for short, this ratio reflects investors’ assessments of those future earnings. You determine the share price of the company’s stock and divide it by EPS to obtain the P/E ratio.
If, for example, a company closed trading at $46.51 a share and EPS for the past 12 months averaged $4.90, then the P/E ratio would be 9.49. Investors would have to spend $9.49 for every generated dollar of annual earnings.
When ratios are properly understood and applied, using any one of them can help improve your investing performance.
Even so, investors have been willing to pay more than 20 times the EPS for certain stocks if hunch that future growth in earnings will give them an adequate return on their investment.
15.9. 5. Debt-Equity Ratio¶
What if your prospective investment target is borrowing too much? This can reduce the safety margins behind what it owes, jack up its fixed charges, reduce earnings available for dividends for folks like you and even cause a financial crisis.
The debt-to-equity is calculated by adding outstanding long and short-term debt, and dividing it by the book value of shareholders’ equity. Let’s say XYZ has about $3.1 million worth of loans and had shareholders’ equity of $13.3 million. That works out to to a modest ratio of 0.23, which is acceptable under most circumstances. However, like all other ratios, the metric has to be analyzed in terms of industry norms and company specific requirements.
15.10. 6. Return on Equity¶
Common shareholders want to know how profitable their capital is in the businesses they invest it in. Return on equity is calculated by taking the firm’s net earnings (after taxes), subtracting preferred dividends, and dividing the result by common equity dollars in the company.
Let’s say net earnings are $1.3 million and preferred dividends are $300,000. Take that and divide it by the $8 million in common equity. That gives a ROE of 12.5%. The higher the ROE, the better the company is at generating profits.