Earnings per Share (EPS) Monday, June 18, 2007
Posted by ei-forum in Understanding Ratios.trackback
This is one of the most widely used ratios when trying to asses a company’s performance. Most analysts use this as the primary variable to determine the share price.
In order to calculate EPS you have to divide the profit attributable to ordinary shareholders by the weighted average of shares outstanding during the financial period. The result is the net income that is being generated per share of the company.
As already mentioned, since this ratio is so important, you will see that analysts are constantly issuing revised earnings estimates. Why? Because, earnings are the most important factor that affects the value of a company. Earnings are the profit a company makes, and a company cannot survive without earnings.
You should not compare the EPS of different companies due to different strategies in terms of numbers of shares outstanding. The most useful way to use this ratio is to look at the growth in EPS over time, which will help us understand the company’s progress.
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Your definition of EPS is correct — up to a point. A more precise definition of EPS would be the following:
EPS = profit attributable to ordinary shareholders / weighted average of outstanding shares during the financial period.
These distinctions are important, particularly when examining companies with more “sophisticated” or complex financial structures. In terms of profit, companies could have several classes of shareholders, some with priority on profit over others (e.g. dividends paid to prefered shareholders). Thus it’s important to pay attention to that portion of the profit that is attributable to ordinary shareholders.
Also, the number of shares outstanding can change dramatically during the financial period causing significant changes in the EPS. For example, a company could issue additional shares or split the stock. Failing to take this into account could greatly distort your interpretation of a company’s financial performance.
Indeed Brian,
You are right! We tried to oversimplify. Things can be more complex with certain companies and the definition should be more precise.
We will edit the post.
Thank you for posting you insightful comment.