The world of investing is littered with terms and jargon that can be confusing and even misleading if you don’t understand what the words and numbers are supposed to mean.
Take earnings per share, for example, which is commonly used as a method of calculating whether a company’s stock price is considered to be good value and worth buying. Do you understand what it is supposed to illustrate and how the figure is calculated?
Here is an insight into earnings per share so that once you are armed with that knowledge and information you be able to become a more accomplished investor.
A way of determining profitability
The fundamental purpose of earnings per share (EPS) is to analyze a company’s financial performance in order to determine whether it is making a profit and how well into the black they are.
It is actually a relatively simple calculation used to arrive at an EPS number.
To calculate the EPS of a company you simply divide their declared net profit, which is the amount they have made after deducting its costs, by the number of common shares it has outstanding.
The general purpose and usefulness of this EPS number is to give you a fair indication of how much money the company is managing to generate for each share of stock. It is regularly used as a basic tool for estimating whether the company is generating value for its shareholders.
The higher the EPS number, the more attractive it might be to investors, as it suggests the company is generating good profits relative to its current share price.
Understanding the number
Although the formula for calculating EPS is straightforward there are a number of variables that can impact and affect the calculation.
For example, it is often the case that a weighted average number of shares is used in the calculation. The reason for this is that the average number of shares in circulation can vary and that could distort the EPS figure.
If you see an annual diluted EPS figure it means it has arrived at the number using a calculation that involves the weighted average number of shares outstanding.
Another thing to look out for in the reporting is when the EPS is described as excluding extraordinary items.
If a company has managed to bank a big profit from the sale of one of its assets, for instance, that will have a positive impact on its profits, but it is not an event that is going to be repeated, so it should not be allowed to distort their usual EPS performance.
It would also be unfair to count an unusual and explainable loss if it is not something that will be repeated, such as a factory shutdown because of COVID-19 restrictions, for example.
Pros and cons of EPS
When a company has a higher EPS it demonstrates good profitability and suggests that money is available for further investments or to be distributed amongst shareholders, which is good news either way.
There are also factors that can unduly influence the EPS number, such as reducing the number of shares in circulation to improve the EPS without actually increasing their net income.
However, as a basic guide to profitability, EPS is a number always worth looking at when you are considering an investment opportunity.