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Sunday, 10 April 2016

Earnings Per Share (EPS) : Calculate EPS , Diluted EPS , EPS Analysis and Breaking Down EPS

The process of critical evaluation of the financial information contained in the financial statements in
order to understand and make decisions regarding the operations of the firm is called ‘Financial
Statement Analysis’. 

Earnings per share (EPS) is the monetary value of earnings per outstanding share of common stock for a company.

In the United States, the Financial Accounting Standards Board (FASB) requires EPS information for the four major categories of the income statement: continuing operations, discontinued operations, extraordinary items, and net income.

Calculating Earnings per share

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Earnings per share (basic formula)
\mbox{Earnings Per Share}=\frac{\mbox{Profit- Preferred Dividends}}{\mbox{Weighted Average Common Shares}}
Earnings per share (net income formula)
\mbox{Earnings Per Share}=\frac{\mbox{Net Income - Preferred Dividends}}{\mbox{Average Common Shares}}
Earnings per share (continuing operations formula)
\mbox{Earnings Per Share}=\frac{\mbox{Income from Continuing Operations - Preferred dividends}}{\mbox{Weighted Average Common Shares}}

Weighted Earnings Per Share Calculation

Modify the basic EPS calculation slightly to arrive at the weighted earning per share calculation. Weighted EPS is a more accurate calculation because it takes into account any dividends that the company issues to shareholders. However, this formula is more complex than the basic earnings per share calculation or the reporting term, so it is not used quite as often even though it is more accurate.  

Locate the company's dividends on preferred stocks. A dividend is an amount of money paid out to stockholders — often quarterly — from the company's profit.
  • For the sake of example, let's take Apple as the company we're trying to arrive at a calculation for. In 2012, Apple announced that it would pay a $2.5 billion dividend quarterly, starting in Q3. That amounts to roughly $5 billion in dividends over the course of the year.

Take the company's net income and subtract the dividends on preferred stock number. Using Apple as an example, a quick search reveals that in 2012, Apple recorded $41.73 billion in net income. Subtract $5 billion from 41.73 to arrive at $36.73 billion.
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Divide the difference by the average number of outstanding shares. Apple's net income minus their dividend in 2012 was $36.73 billion. Divide this amount by the amount of shares outstanding, 934.82 million, to arrive at a weighted EPS of roughly 39.29.  

Calculations of diluted EPS under U.S. GAAP are described under Statement No. 128 of the Financial Accounting Standards Board (FAS No. 128).[5] The objective of diluted EPS is to measure the performance of a company over the reporting period taking into account the dilutive effect of potential common stock that could be issued by the company. To compute diluted EPS, both the denominator (outstanding shares) and the numerator (earnings) may need to be adjusted.
Diluted shares: To calculate the total number of shares used in the calculation, FASB prescribes using the treasury method to calculate the dilutive effect of any instruments that could result in the issuance of shares, including:
  • Stock options
  • Warrants
  • Convertible preferred stock
  • Convertible bonds
  • Share-based payment arrangements
  • Written put options
  • Contingently issuable shares
Earnings: The numerator used in calculating diluted EPS is adjusted to take into account the impact that the conversion of any securities would have on earnings. For example, interest would be added back to earnings to reflect the conversion of any outstanding convertible bonds, preferred dividends would be added back to reflect the conversion of convertible preferred stock, and any impact of these changes on other financial items, such as royalties and taxes, would also be adjusted.

Valuation Ratios

Earnings per share
Cash earnings per share
Dividend per share
Book value per share

Significance: It provides a measure of degree to which current assets cover current liabilities. The excess of current assets over current liabilities provides a measure of safety margin available against uncertainty in realisation of current assets and flow of funds. The ratio should be reasonable. It should neither be very high or very low. Both the situations have their inherent disadvantages. A very high current ratio implies heavy investment in current assets which is not a good  sign as it reflects under utilisation or improper utilisation of resources. A low ratio endangers the business and puts it at risk of facing a situation where it will not be able to pay its short-term debt on time. If this problem persists, it  may affect firms credit worthiness adversely. Normally, it is advocated to have this ratio as 2:1.

Norms and Limits

It should be noted that two different companies could generate the same EPS but one could do so with a lesser equity. All other things being equal, this company is better than the other one because it is more efficient at using its capital for generating profits.


Diluted EPS is EPS calculated after assuming that all convertible securities are converted. Convertible securities such as employee stock option, convertible preference share, convertible debentures etc. It is the EPS after giving effect of such securities on both numerator and denominator of the EPS. The numerator will be increased by the amount of dividend or interest which will not be paid in the event of conversion of such securities. The denominator will be increased by the no. of equity shares issues as a result of such conversion.
So, the formula becomes

Earnings per Share of Common Stock

After recognizing the preferred stockholders' required dividend, there was $7,300 ($10,000 minus $2,700) of earnings available for the common stockholders. The $7,300 was earned throughout the year, so we need to divide that amount by the weighted-average number of shares of common stock outstanding throughout the year:
The earnings per share (EPS) of common stock = earnings available for common stock divided by the weighted-average number of common shares outstanding:

Earnings Per Share Analysis:

The earnings per share ratio is mainly useful for companies with publicly traded shares. Most companies will quote the earnings per share in their financial statements saving you from having to calculate it yourself. By itself, EPS doesn't really tell you a whole lot. But if you compare it to the EPS from a previous quarter or year it indicates the rate of growth a company's earnings (on a per share basis). Cory's Tequila Co.'s EPS have increased almost 50% since last year, an excellent growth rate.

It should be noted that the 65 cents EPS is a "trailing" number, using the previous 4 quarters of earnings. Some analysts like to use "projected" EPS to analyze a stock's current value using future estimates.

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Activity (or Turnover) Ratios

The turnover ratios basically exhibit the activity levels characterised by the capacity of the business to make more sales or turnover. The activity ratios express the number of times assets employed, or, for that matter, any constituent of assets, is turned into sales during an accounting period. Higher turnover ratio means better utilisation of assets and signifies improved efficiency and profitability, and as such are known as efficiency ratios. The important activity ratios calculated under this category are :

                                 1. Stock Turn-over;
                                  2. Debtors (Receivable) Turnover;
                                    3. Creditors (Payable) Turnover;
                                      4. Investment (Net Assets) Turnover
                                        5. Fixed Assets Turnover;
                                           6. Working Capital Turnover.

BREAKING DOWN 'Earnings Per Share - EPS'

Earnings per share is generally considered to be the single most important variable in determining a share's price. It is also a major component used to calculate the price-to-earnings valuation ratio.
For example, assume that a company has a net income of $25 million. If the company pays out $1 million in preferred dividends and has 10 million shares for half of the year and 15 million shares for the other half, the EPS would be $1.92 (24/12.5). First, the $1 million is deducted from the net income to get $24 million, then a weighted average is taken to find the number of shares outstanding (0.5 x 10M+ 0.5 x 15M = 12.5M).
An important aspect of EPS that's often ignored is the capital that is required to generate the earnings (net income) in the calculation. Two companies could generate the same EPS number, but one could do so with less equity (investment) - that company would be more efficient at using its capital to generate income and, all other things being equal, would be a "better" company. Investors also need to be aware of earnings manipulation that will affect the quality of the earnings number. It is important not to rely on any one financial measure, but to use it in conjunction with statement analysis and other measures.

Number of Equity Shares Outstanding: The no. of existing equity shareholders is taken. If the number of equity shares changes in the financial period, a weighted average for equity shares is calculated. Weights shall be given according to the no. of days or months outstanding during the year. Let us understand this with the help of an example.

 Here is a video that can explain it better

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