Any company which is floated on the stock exchange has shareholders. People who have invested their cash in return for both a voice (when appropriate) in how things work, and a share in the company profits. Of course, nothing is guaranteed, and the value of stocks and shares can rise and fall dramatically and unpredictably, but the basic expectation remains true.
On the other side, those who run a company are equally keen to see a healthy profit and be able to feel confident about paying shareholders a decent return (or dividend); after all, good results count for a large part of why they keep their jobs.
So we know that if there’s one thing that investors are keen to learn it’s the dividend that each share they hold is going to pay out. These figures are usually reported by companies either every three months or just once a year, and they are usually listed as earnings per share. So in a sentence, earnings per share is the way profit made by a company is measured.
What is the earnings per share formula and how is it calculated?
This is calculated by subtracting the preferred stock dividends paid from the net income
1. Calculate net income
2. Calculate the cost of preferred stock dividends.
3. Subtract #2 from #1. This figure is the total amount of earnings payable to common stockholders.
4. Divide the figure from #3 by the number of outstanding shares
5. Voila, you have the EPS
Now let’s put this into an example to show how it works in practice
1. Company ABC has made a net profit of $10 million.
2. Preferred stockholders get $1million.
3. The total amount payable currently is $9 million.
4. There are $5.5 million outstanding shares so we must calculate
$9 million/5.5 million shares = company earnings are $81.50 per share
Stop – it’s not quite as simple as that
In the example above you may have noticed the term ‘preferred stock’, and it is important to understand the difference between those shares and the regular, or ‘common stock’ which is what most people deal with.
What is preferred stock?
These are shares that do not (generally) offer any voting rights to those who hold them. They are more likely to be purchased by individual investors, and although they don’t give the buyer any say in how the company runs they do bring other benefits. These include, in most cases, a higher dividend per share than common stocks, and preference over common stockholders if dividend payments are delayed for some reason or for compensation should the company go into bankruptcy.
The value of preferred stock tends to fall when interest rates rise, and vice versa, while the value of common shares depends on supply and demand. They also have the advantage of being subject to immediate callback by the issuer – and this often brings rich rewards. Preferred shares can be converted to common shares, but this doesn’t work the opposite way. Regardless of the attractions of preferred stock in the long term common stock tends to do better overall.
Diluted earnings per share
This term refers to the dividend paid out in situations where there are preferred shareholders. As their shares are worth more than the common equivalent the payment to common shareholders is ‘diluted’ by a larger proportion being paid out elsewhere.
What is the earnings per share [EPS] formula used for?
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- Attracting more investors
When a healthy earnings per share statistic is released it’s not uncommon for stock prices to rise, which of course means more money is generated to either invest further in the company or to be fairly distributed amongst those who have invested.
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- Highlighting a company’s strength in the market
It’s a pretty important factor in deciding whether a company is doing well financially, or struggling, which in turn can affect the way people react to it as an investment.
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- A measurement tool
EPS is one of the few ways financial experts and commentators can compare two similar companies and see how they perform against each other.
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- EPS can track a company over the long term
Here the earnings per share formula can be a really useful tool for potential investors who want to know how a company has done over several years of trading. Obviously, the most positive scenario is one where the EPS rises every year, even if only by a little; while those with a declining or fluctuating EPS may not seem as attractive.
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- EPS results help you decide if a share is a good value
Those looking to invest immediately can take a look at a company’s EPS ratio and decide if it is worth the price being asked for as a result of comparing the two. (This can have an unfortunately negative effect on companies that choose to reinvest their profits to grow the business.)
How valid are the earnings per share dollar amount?
It can be a useful tool but it would be unwise to over-rely on it considering the factors which can create a less-than-accurate real measure of a company’s worth. These include such things as there is no account taken of a company’s debt, how much capital they drew on to reach the EPS levels on the table, and that it is possible to manipulate EPS results by buying their own shares back and therefore skewing the final figures.
