The primary purpose of investing in shares is to earn good returns. These returns can be in the form of capital gains upon liquidation of the shares held or through dividends declared by the company or the earnings per share (EPS) held by the investors. The earnings per share are an important barometer to determine the financial health of the company and determine the ultimate returns earned by them. Hence, it is quite crucial to keep track of the EPS of any company for maintaining a healthy portfolio as well as include more profitable investments.
Given below is the meaning of the term EPS and the relevant details for the same.
What is EPS?
EPS or earnings per share are post-tax returns distributed by the company to its shareholders. These returns allow the investors to get the true picture of the returns generated by their portfolio for the various shares held by them. EPS are the true returns earned on the outstanding shares of the company. These shares are the common shares or the ordinary shares and do not include the preference shares of the company.
How is EPS calculated?
The EPS Formula is given below
EPS = (Profit after Tax – Dividend on Preference Shares) / Total number of outstanding shares of a company
Preference dividends are paid first out of the profit after tax as preference shareholders have a higher claim to the post-tax returns than the equity shareholders. The net profit after tax and preference dividends shows the actual returns earned by the shareholders for a given period of time.
Let us consider the following example to understand the calculation of EPS better.
Company A has declared post-tax returns of Rs. 1,00,000 and the preference dividend to be paid is Rs. 20,000. The total number of outstanding ordinary shares of the company is 40,000. The EPS, in this case, can be calculated as under.
EPS = (100000-20000) / 40000
EPS = Rs. 2 per share.
What is the importance of EPS?
EPS is an important financial tool to determine the financial health of a company. If a company is consistently providing higher EPS, then such a company is considered to be highly profitable and has a stable business model EPS with good growth aspects. EPS is regularly reviewed by financial analysts, investors, as well as the management of the company to ensure that the company is on the right track.
From the investor’s point of view, a company providing consistently higher EPS is a safe bet for long-term investment in the shares of such a company. Moreover, reviewing the EPS of the shares held in the portfolio as well as other competitive shares in a similar segment ensures that the portfolio of the investor is profitable. When a company is not providing adequate returns, the investor can view the EPS and other financial ratios of other companies in the same industry to alter their portfolio and ensure maximum profitability.
What are the types of EPS?
Some of the basic types of EPS are mentioned below,
1. Trailing EPS
Trailing EPS is also known as trailing twelve months EPS. It is calculated based on the data of the previous year of the company. The net profit of the company in the past year and their outstanding shares held by the company at the end of the year are considered in the calculation of trailing EPS that data is past data it can be used only as a reference point and does not imply that the current EPS and the future EPS would be the same
2. Current EPS
Current EPS is calculated based on the date of the current year. The company can use the factual data of the quarters that have been declared and can use the budget and values for the future quarters of the year.
3. Forward EPS
Forward EPS is one of the most important factors that is often reviewed by investors and analysts. It is based on the projected earnings of the company for the following financial year. Although the data of the company is not factual and is budgeted based on assumptions and past trends, forward EPS is crucial for the company and investors in making investment decisions.
4. Adjusted EPS
Adjusted EPS is also crucial as it reflects the earnings of the company in the normal course of business. It removes any extraordinary item or non-recurring or non-regular item from the calculation of EPS. This provides the true earnings of the company in the normal course of business and thereby the normal EPS that is earned by the shareholders.
5. Cash EPS
Cash EPS is used to know the EPS earned on the exact cash earnings of the company. It is calculated as the ratio between operating cash flow and the diluted shares outstanding of the company.
What are the limitations of EPS?
Some basic limitations of EPS are given below,
- EPS does not always consider the actual cash inflow and outflow in a company. a company having a serious cash crunch but a higher EPS can give the investors a wrong picture and show the company to be in a profitable position which is not the true case
- Also, EPS cannot be reviewed as a standalone barometer for the profitability of the company. The EPS of a company can be manipulated or window-dressed to show a profitable position of the company and thereby mislead the investors. It is therefore important to ensure that investors look at other financial ratios as well as the past performance of the company to make sound investment decisions.
EPS shows the earnings that are earned by a shareholder on every share held by them. Comparing the past EPS and the present EPS is also an excellent yardstick to measure the financial performance of the company as well as make future projections regarding the growth potential of the company. However, as mentioned above, it is important to note that EPS alone is not the measure of the profitability of a company. It is important to have a holistic approach in reviewing the true financial position of a company.
Diluted EPS is the refined version or a modified version of the calculation of correct EPS. It also considers all the convertible securities ( convertible debt, preference shares, etc.) In the calculation of EPS. This shows the true it is owned by the shareholders even if the convertible securities are not converted at the moment but will be included in the common shares at a future date. Therefore, the diluted EPS is always smaller than basic EPS.
The absolute cash earned by a company is not reflected in the EPS of the company and hence, a company facing a severe cash crunch may show a higher EPS but will not represent the true financial position of the company.
No. Current EPS factors the factual figures of the quarters already declared for the year as well as the future projections of the balance quarters for the financial year.
The formula for diluted EPS is,
Diluted EPS = (Net Income after tax + Convertible Preferred Dividend + Debt Interest) / All convertible securities plus common shares.