If you’ve been following stock market news you would’ve come across reports from analysts and observers fretting about Earnings per share or EPS. All this focus should have you at least wondering what it is about and why it is so important to market observers. Let’s discuss the ins and outs of earnings per share, what it tells us about companies and what it means for us as investors. We will also talk about the different types of earnings per share including the basic, headline, diluted and ongoing earnings per share.
EPS
Earnings per share is a measure used to calculate the profit of the company that is attributable to individual shareholders. The rationale is that companies report combined profits but individual shareholders would like to know how much is attributable to them. The easy way to do this is to calculate how much of the profit is attributable to an individual share and then the shareholder in question can work out what this means for them. Since the earnings are divided amongst the shares equally, the earnings per share tell us all we need to know. It also follows that shareholders buy or sell individual shares though sometimes in lots of 100 or 1000, so stating the earnings per share helps us understand the performance attributable per share and allows further use of the information in important ratios such as the price-earnings ratio (P/E ratio).
Earnings
As stated before earnings of a company means profit. Now there’s a need to clarify which profit we mean and financial statements have many different types of earnings. In simple language, the earnings are net profit, the one after deducting operating expenses. If you’re looking at a financial statement it is normally stated as EBITDA or Earnings Before Interest, Tax, Depreciation and Amortisation.
Shares
The number of shares used in the earnings per share calculation is the number of outstanding shares of the company and this can be found in the financial statements usually in the notes to financial statements. Where there has been a change in the number of shares during the year you may find the average of the initial and final number of shares in issue is used.
The formula used to calculate earnings per share is as follows;
As you can see the result you will derive from this is a number usually expressed in cents per share. This doesn’t give us much information when standing alone. However when we compare the number through time (for example with previous years) or apply it to a ratio such as the Price-earnings Ratio or Earnings yield it can give us quite a lot of insight into the company performance and what to expect.
Types of EPS
So now that we have the basic idea of EPS and what it means let’s delve into some of the headings we are likely to see when it comes to the EPS section of financial statements or what we may see in media reports.
Headline earnings per share
Headline earnings per share refer to the earnings made from all sources. You would appreciate that companies are oftentimes in the position of being investors and therefore earning income from their investments. Users of financial information appreciate a distinction between income from all sources and income from business operations.
Basic earnings per share
Basic earnings per share are those earnings purely from the business operations of the company. This is profit from sources where the company is involved in carrying on business activity of some sort. If you are looking at EPS as an assessment of company performance you will be most interested in this one.
Diluted EARNINGS PER SHARE
This is the most complicated of the types of earnings per share to understand. When we looked at the formula for earnings per share we noted that the number of shares is the denominator. The name was given to events that increase the number of outstanding shares is dilution because it reduces the earnings per share. Dilutive events will have an impact on the number of shares but not the earnings. Diluted or diluted earnings per share or dilutive earnings per share is the earnings per share we get when we use the new number of shares after a dilutive event. What makes it complicated is that the event that causes the rise in the number of shares may not have occurred yet, therefore it is a disclosure of the effect the dilutive event will have on EPS. An example is awarding shares to employees or management which may be pending Annual General Meeting approval.
Ongoing EARNINGS PER SHARE
Finally, you may come across “ongoing earnings per share” or “earnings per share from ongoing operations”. You will see this one in cases where there is a change to the composition of a business usually the acquisition or disposal of a business unit. Where a business unit was disposed in the financial year you can understand that it contributed to earnings during the year. Going forward it will not and thus this forms a disclosure of what to expect in future earnings per share or comparability with future periods.
The simplicity of the EPS leads many people to underestimate its importance. In my mind, its importance is overshadowed only by the price-earnings ratio and it is always the first thing I look for in a financial statement. Why, is a discussion for another day.
