Part 25 Understanding EPS: What It Tells About a Company
Part 25 Understanding EPS: What It Tells About a Company & Its Types
Earnings Per Share (EPS) is a key financial metric that measures a company's profitability on a per-share basis.
It’s widely used by investors to assess a company’s financial health, compare it with peers, and make informed decisions about buying or selling shares.
Below, I’ll explain EPS in detail, what it shows, how investors use it, its limitations, and other relevant aspects.
What is EPS?
EPS represents the portion of a company’s net income (profit) allocated to each outstanding share of common stock.
It’s calculated as:
EPS = (Net Income − Preferred Dividends) ÷ Weighted Average Number of Outstanding Shares
Net Income: The company’s total profit after taxes and expenses.
Preferred Dividends:
Dividends paid to preferred shareholders, which are subtracted because EPS focuses on common shareholders.
Weighted Average Number of Outstanding Shares:
Accounts for changes in the number of shares during a period (e.g., due to stock issuances or buybacks).
EPS is typically reported quarterly and annually in a company’s financial statements.
Types of EPS -
Basic EPS:
Uses the actual number of outstanding shares.
Formula: (Net Income − Preferred Dividends) ÷ Weighted Average Shares
Reflects the earnings available to existing common shareholders.
Diluted EPS:
Accounts for potential dilution from convertible securities (e.g., stock options, convertible bonds, or warrants).
Formula: (Net Income − Preferred Dividends) ÷ (Weighted Average Shares + Dilutive Shares)
Provides a more conservative estimate, assuming all convertible securities are exercised.
Adjusted EPS:
Excludes one-time or non-recurring items (e.g., gains/losses from asset sales, restructuring costs).
Gives a clearer picture of ongoing operational performance.
Trailing EPS:
Calculated using net income from the past 12 months.
Based on historical data, so it’s more concrete but backward-looking.
Forward EPS:
Based on analysts’ forecasts for future earnings.
Useful for estimating future performance but less reliable due to uncertainty.
What Does EPS Show?
EPS provides insight into a company’s profitability and efficiency in generating earnings for shareholders.
Key points:
Profitability:
Higher EPS indicates better profitability per share, suggesting the company is generating more income for shareholders.
Example: A company with an EPS of $5 is more profitable per share than one with an EPS of $2, assuming similar share counts.
Company Performance:
EPS growth over time signals improving financial health or operational efficiency.
Declining EPS may indicate challenges like rising costs, falling revenue, or increased competition.
Comparability:
EPS allows investors to compare companies within the same industry, regardless of size, as it’s a per-share metric.
Example: Comparing EPS of Infosys and TCS helps assess which is more profitable per share.
Shareholder Value:
EPS reflects the earnings available to common shareholders, which can be reinvested, used for dividends, or retained for growth.
How Investors Use EPS to Decide Whether to Buy or Not Buy Shares
EPS is a critical factor in investment decisions, but it’s rarely used in isolation. Here’s how investors leverage EPS:
Evaluating Profitability:
High or Growing EPS: A consistently increasing EPS suggests a company is growing and managing costs effectively, making it attractive to investors.
Example:
If Reliance Industries reports a rising EPS over several quarters, it may signal strong operational performance, encouraging investors to buy.
Low or Negative EPS: A declining or negative EPS (indicating losses) may deter investors unless there’s a clear turnaround plan.
Example: Byju’s negative EPS in recent years due to losses raised red flags for investors.
Price-to-Earnings (P/E) Ratio:
EPS is used to calculate the P/E ratio: P/E = Current Share Price ÷ EPS.
A lower P/E ratio may indicate an undervalued stock (a potential buy), while a high P/E suggests overvaluation or high growth expectations.
Example: If a company’s share price is $100 and EPS is $5, the P/E is 20. If peers have a P/E of 15, the stock may be overvalued.
Investors compare P/E ratios across similar companies to identify undervalued or overvalued stocks.
EPS Growth Rate:
Investors look for consistent EPS growth, which indicates a company’s ability to scale profits.
A high growth rate (e.g., 15%+ annually) may justify buying, especially for growth-oriented companies like tech firms.
Example: Nvidia’s EPS growth in 2024–2025, driven by AI demand, made it a favorite among growth investors.
Comparing Basic vs. Diluted EPS:
If diluted EPS is significantly lower than basic EPS, it signals potential dilution from stock options or convertible securities, which could reduce future shareholder value.
Investors may avoid companies with high dilution risk unless growth prospects are strong.
Dividend Potential:
Companies with high EPS often have more cash to pay dividends, appealing to income-focused investors.
Example: A company like HDFC Bank with stable EPS growth is more likely to maintain or increase dividends, attracting dividend investors.
Industry and Market Context:
EPS must be evaluated relative to industry norms. For example, tech companies may have higher EPS volatility than utilities.
Investors compare a company’s EPS to its peers to gauge relative performance.
Example: TCS’s EPS of ₹48 in 2024 is strong within the IT sector, but comparing it to a bank like SBI requires context.
Forward EPS for Growth Stocks:
For companies with low current EPS but high growth potential (e.g., startups), investors rely on forward EPS estimates.
If analysts predict strong future EPS, investors may buy despite current low or negative EPS.
Example: Zomato’s negative EPS in its early years didn’t deter investors betting on future profitability.
Most Important Tip How to Read Understand EPS
Buy Signals:
Rising EPS with strong fundamentals (revenue growth, low debt).
Low P/E ratio compared to peers, indicating undervaluation.
Positive forward EPS estimates for growth stocks.
Avoid Signals:
Declining or negative EPS without a clear recovery plan.
High P/E ratio suggesting overvaluation.
Significant dilution risk shown by a large gap between basic and diluted EPS.
Context Matters: Always compare EPS with industry peers, market conditions, and other financial metrics.
Long-Term View: Focus on EPS trends over multiple quarters rather than a single report.
