To anyone who is new in the market and learning the concepts, you must have heard of the word EPS which is nothing but Earning Per Share. It is an important financial measure which indicates the profitability of a company. It indicates how much a company makes for each of its stock and is a widely used metric for estimating corporate value. Let’s learn more about it and its type in detail.
Earnings Per Share, or EPS is an important financial tool which shows the profitability of the company. When EPS is spoken about, it is generally either Basic EPS or Diluted EPS. Basic EPS is calculated by dividing the company’s net income by its total outstanding shares during a given period. The formula to calculate is given below
Diluted EPS takes into consideration all the potential dilution which could take place due to stock based compensation,and convertible securities. Diluted EPS can be calculated by subtracting preferred dividends from a company’s net income and dividing this by the number of outstanding and dilutive shares. The formula is mentioned below.
Basic and Diluted EPS are similar in nature, but differ on principle. Basic EPS is a simple measure of profitability and hence it is a more easily understood, even by new investors.Whereas diluted EPS is a more complicated technique. Most new investors find it difficult to understand diluted EPS.
While basic EPS is simpler, it is not a very practical and realistic approach to calculate the value of a company. Diluted EPS gives a more pragmatic approach and explanation of how the company is performing based on the capital deployed after taking into consideration dilution of securities. It is not ethical for companies to issue preference shares, or convertible preference shares without showing their potential for dilution.
The calculation of diluted EPS is quite an intricate process and requires a lot of data. Basic EPS is easily computed by finding the difference between net income and preferred dividend, and then dividing the same by outstanding equity shares. The calculation of diluted EPS requires identifying all potential shares and financial instruments that can result in more shares in the future. These include the following
Diluted EPS is computed by totaling the sum of net income, convertible preferred dividend, and debt interest, and dividing the same by outstanding shares plus the effect of dilution as an impact of convertible securities of the company.
Basic EPS ideally works for small companies whose capital structure is fairly simple. When a company does not have convertible preference shares, or other prospective diluters, then basic EPS will suffice. Conversely in larger companies, who have a more intricate capital structure, and high potential for dilution in the form of convertible preference shares, diluted EPS is the preferred method that should be followed.
Calculation of EPS is one of the basic steps to calculation of the Price to Earnings Ratio (P/E Ratio), it helps in the valuation of the company. Therefore the more in depth and accurate the EPS, the better it is.
Basic EPS is a good estimate of a company’s current profitability, while diluted EPS is more scientific and pragmatic, and it makes a provision for potential dilution, so that there is no misrepresentation of the books to the shareholders.
From a practical aspect, the diluted EPS is more prudent as it takes into consideration the potential impact of dilution of convertible shares and securities.Thereby showing a more complete EPS value, and that in turn gives a more efficient P/E ratio.
Where basic EPS assumes only issued, and outstanding shares of a company, the diluted EPS takes into consideration the potential impact of common share price, preference shares,stock options, partially convertible debt, and fully convertible debt.
The difference can be summarised in the table below
Basic EPS | Diluted EPS |
Only basic earnings of the company per equity shares | Revenues of the company for every convertible share |
Helps in evaluating the profitability of the company | Helps in assessing the profitability of the with convertible securities |
Not accurate as it does include convertible shares | More thorough and detailed in nature |
Common shares included in calculation | Common shares, stock options, preferred shares, debts, warrants all included in the calculation |
Easy to understand and use | More complex and detailed to understand |
Conclusion
Investors buy shares of companies in order to earn dividends and so that they can sell the shares at a higher price in the future. The EPS of a company determines the dividend payments, and the value the share is trading at. Therefore the EPS is a very essential tool to retail investors.
Prospective investors need to be aware of which method of calculation of EPS will be mentioned in the financial statements of the company and how it affects the company. Knowing the difference between basic and diluted EPS is essential to prospective investors, so that they can make good investment decisions.
Earnings per share or EPS, indicates how much money a company makes for each share of its stock, and is a commonly used measure to estimate the financial position of the company.
Earnings per share is one of the most important variables for determining a company’s share price. A high EPS denotes that a company is profitable, and has sufficient profits to distribute dividends to its shareholders.
A company is mandatorily required to disclose their basic as well as diluted EPS in its financial statements.
The EPS of a company will be negative when a company's net income is negative. This means that they are spending more than they are earning.
The Price to Earnings Ratio or P/E Ratio is stock price divided by EPS. EPS is the basic measure of a company's profitability, and is denied as net income divided by total outstanding shares.
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