Algo Trading Byte

We have been covering Market Value Ratios in our series of articles. In our previous two articles we covered Dividend Payout Ratio and Dividend Yield. In this article we are going to cover yet another Market Value Ratio – EPS.

In simple terms, EPS represents the portion of a company’s profit that is allocated to each outstanding share of its common stock.

Earnings Per Share (EPS) = (Net income - Dividend on Preferred shares)/ Net Average outstanding shares

Let’s break down the components:

Net Income: This is the company’s profit after all expenses, including taxes and interest, have been deducted. You can find this number at the bottom of the company’s income statement.

Preferred Dividends: These are dividends paid to preferred shareholders. They are subtracted from net income because EPS measures the earnings available only to common shareholders.

Weighted Average Common Shares Outstanding: This is the average number of shares of common stock that were in the market during the reporting period (e.g., a quarter or a year). It’s weighted because it accounts for any new shares issued or repurchased by the company during that time.

Example:

Let’s us try to understand with a case study of an ABC corporation that had net income of $9876 and had total number of outstanding shares of 10,000. This gives an EPS of 0.99 per share which means company has generated an earning of 0.99$ per each outstanding share.

Types of EPS

It’s important to know that there isn’t just one type of EPS. Here are the most common variations:

Basic EPS: This is the standard calculation as described above, using the number of shares currently outstanding.

Diluted EPS: This is a more conservative measure. It accounts for all potential shares that could be created from convertible securities like stock options, warrants, or convertible bonds. If these securities were converted into common shares, the total number of shares would increase, “diluting” the earnings per share. This is often the more important number for investors to watch as it shows a worst-case scenario.

Trailing EPS: This is calculated using the company’s earnings from the past 12 months (the last four quarters). It is a backward-looking metric based on real, reported data.

Forward EPS: This is a projection of a company’s future earnings, usually for the next 12 months. It is based on analysts’ estimates and management’s guidance, so it is a forward-looking and less certain figure.

Why is EPS So Important?

• Profitability Indicator: It’s a quick and direct way to see how profitable a company is on a per-share basis.
• Comparison Tool: It allows for easy comparison of profitability between different companies, especially those in the same industry.
• Component of the P/E Ratio: EPS is the “E” in the widely used Price-to-Earnings (P/E) Ratio. This ratio divides a company’s stock price by its EPS to show how much the market is willing to pay for each rupee of a company’s earnings.
• Trend Analysis: A company with a consistently growing EPS over time is generally seen as financially healthy and a good investment, as it shows it is becoming more profitable.

In summary, EPS is a fundamental tool that helps investors gauge a company’s profitability, analyze its financial health, and make more informed investment decisions.