Importance of EPS in equity valuation and how it’s calculated

Earnings per share stand to be one of the most clear-cut financial measures a student would come across in his equity valuation studies. 

In very simple terms, EPS actually works out the dollar profit a company has made for each shareholder; hence, such a number happens to be extremely important while trying to find out how much a firm’s stock is worth.

EPS helps the investors to have an idea about the financial health of the company so that they can invest in it, sell it, or hold a stock of it. Thus, it is indispensable to know EPS and its formula while making equity valuation decisions.

What is the Importance of EPS in equity valuation?

EPS is the bottom of the equity valuation for several reasons, which are all directly connected with the ability to express very important information relative to a company’s profitability and growth. 

Key reasons that make EPS important

• DIRECT PROFITABILITY MEASURE

EPS is a measure of how profitable a company is on a per-share basis and surely one of the most important considerations for investors. It illustrates the amount of money a company earns for every share issued of its stock.

The more EPS and hence more profiles being made by the company for its shareholders, the more confidence this instills in investors, and often the higher the resultant stock price.

• INTER-COMPANY COMPARISON

EPS is widely used only for the purpose of comparison; similar sectors are performing with efficiency or not by using EPS. Supposing there are two companies that come under the same sector with the same dollar figure of revenue, but one has a much higher EPS, it shall be considered a more efficient company in regard to converting revenue into a profile. This efficiency can be crucial in the selection of the investment company.

• PRICE-TO-EARNING (P/E) RATIO VALUATION RATIO

EPS is a key constituent of the most widely used price-to-earning (P/E) ratio, which is a valuation method. 

The P/E ratios follow:

P/E Ratio=Price per share EPS

A low P/E ratio can be regarded as a reason the stock is underpriced in terms of earnings. On the other hand, a high P/E ratio could be believed to be such that a stock is overpriced. This ratio will serve to help the investor know whether the growth in price that has been accumulated by stock is justified in terms of the earnings of the firm. Besides, such a crucial characteristic had also led to the calculation of equity’s value, and without EPS, such a highly valued valuation metric would have never emerged at all.

• EPS AS A GROWTH INDICATOR

Long-term growth in EPS might reflect long-term sustainable and concurrent growth in any company. Long-term growth in EPS can be related to both sustainable and concurrent growth in any organization. There must always be an EPS every year, and that should be greater than the EPS of previous years.

Every investor needs companies that have an EPS with a proven track record of growth, and that doesn’t say much about the business model, but it does show some good operational performance, competitive advantage, and so on.

In the case of an increase in EPS, it indicates that the company is reinvesting all its earnings in growth opportunities or optimizing its better use of resources, hence good for growth as well as for value investors.

• EPS AND DIVIDEND PAYMENTS

Hence, whereas for the income seeker EPS does not turn out to become an indicator of expected dividend distributions, normally earnings can be used in an attempt to drive the capability of a firm to pay dividends. Companies with stable, high EPS tend to continue paying the same dividends to their shareholders over time. In addition, enhanced EPS may generate expectations for a higher dividend pay-out in the future; consequently, this stock becomes more appealing to income seekers also.

• EFFECT ON STOCK PRICE

There is always a positive effect of announcements of EPS reporting of any company that enhances its share price because the announcements do affect the stock prices.

When a company reports an EPS figure higher than what the market had thought, it can lead to an up-spike in the stock because investors feel that future performance would be great.

When EPS comes in less than what the market expects, it can trigger decreased stock prices because investors reassess the value of the company.

How is EPS calculated?

Having set up the basics of EPS in equity valuation, it is time to find out how EPS is calculated. It is calculated into two types: basic EPS and diluted EPS.

• Formula for Basic EPS

The simplest form of the EPS calculation would be basic EPS. This simply refers to net income available for common stock, divided by the weighted average number of outstanding shares over the period. This formula applies when using basic EPS in computation.

Basic EPS =

Net Income: This is the profit generated from the operation of the company after all expenses and taxes are accounted for.

Add back preferred dividends paid by preference shareholders to current income because Basic EPS is calculated on earnings available to common shareholders.

Weighted Average Shares Outstanding adjusts for a change in outstanding shares over the course of a reporting period, for instance, common stock bought back or new common shares issued.

Now let’s take an example. Suppose a firm has net income of $2 million, no preferred dividends, and 1 million weighted average shares outstanding. Then Basic EPS would be like this:

Text {Basic EPS} = frac{2,000,000}{1,000,000} = 2.00

That is, the company earned $2 for every common stock share.

• DILUTED EPS CALCULATION

Diluted EPS takes all the extra shares that would exist if such convertible securities as stock options, warrants, or convertible debt were issued.

The calculation yields more cautious EPS to the investors, for in the formula, all the outstanding dilutive securities are assumed to convert into common stock and thereby decrease the earnings per share.

The formula for diluted EPS is

DSEPS = Net Income – Preferred Dividends / Weighted Average Shares Outstanding + All Dilutive Securities

The same company, considering other 100,000 stock options that could possibly dilute the shares, would be:

DSEPS = 2,000,000 / 1,000,000 + 100,000  1.82

This is the diluted quantity, keeping in mind all the possible shareholders’ dilution of this issuing company and taking a cautious view of the company’s earnings per share.

Conclusion

EPS is one of the easiest measures that is used in determining the value of equity. It presents a statement of the profit that the company makes on a per-share basis; hence, it is the most relevant input in establishing the intrinsic value of the company against peer values for fair valuation decisions on whether to buy and hold stocks or sell them.

Adding knowledge of how to calculate both basic and diluted EPS adds insight, then, to the real financial health and growth prospects and value that may be obtained from a company.

It remains perhaps the most basic yet fundamental input tool in equity valuation when compared versus firm profitability or as an indicator of expected dividends.