Lesson 7 - Intermediate Accounting Course 

7. Earnings per Share (EPS) and Its Importance in Financial Analysis

Earnings per Share (EPS) is one of the most important financial metrics used by investors and analysts to evaluate a company's profitability. It represents the portion of a company’s profit allocated to each outstanding share of common stock. A higher EPS generally indicates better profitability and financial health, making it a key indicator for investment decisions.

1. What Is Earnings per Share (EPS)?

EPS is calculated using the following formula:

• Net Income: The company’s total earnings after expenses, taxes, and interest.

• Preferred Dividends: Payments made to preferred shareholders, subtracted because EPS only measures earnings available to common shareholders.

• Weighted Average Shares Outstanding: The average number of common shares in circulation during a period.

Example Calculation:
A company reports a net income of $1,000,000, pays $50,000 in preferred dividends, and has 500,000 weighted average shares outstanding.

This means the company earned $1.90 per share during the period. 

2. Types of EPS

1️⃣ Basic EPS

• Uses only outstanding shares in the calculation.

• Formula:

2️⃣ Diluted EPS

• Accounts for potential shares that could be issued through stock options, convertible securities, or other financial instruments.

• Formula:

• Why It Matters: If a company has a large number of convertible securities, its EPS could be lower when all potential shares are included.

3️⃣ Trailing EPS vs. Forward EPS

• Trailing EPS: Based on the past 12 months of earnings (historical performance).

• Forward EPS: Based on projected future earnings (expected performance).

3. Why Is EPS Important in Financial Analysis?

✅ Measures Profitability

• A higher EPS indicates that the company is generating more profit per share.

✅ Used in Valuation Ratios

• EPS is a key component in the Price-to-Earnings (P/E) ratio, a widely used valuation metric:

• A high P/E ratio suggests that investors expect high future growth, while a low P/E ratio may indicate an undervalued stock.

✅ Comparing Companies

• EPS allows investors to compare the profitability of companies within the same industry, regardless of their size.

✅ Indicator of Financial Stability

• Consistently increasing EPS over time suggests strong company growth and financial health.

4. EPS Limitations and Considerations

⚠ EPS Alone Is Not Enough

• A company may have a high EPS but poor cash flow, excessive debt, or accounting manipulations that make its earnings look better than they are.

⚠ Impact of Share Buybacks

• Companies can artificially boost EPS by repurchasing shares, reducing the number of outstanding shares without actually increasing profits.

⚠ Industry Differences

• EPS should always be compared within the same industry. Some industries naturally have higher EPS due to different capital structures and profit margins.

5. Final Thoughts

Earnings per Share (EPS) is a fundamental metric for evaluating a company's profitability and investment potential. However, while a high or growing EPS is generally a positive sign, it should always be analyzed alongside other financial indicators, such as revenue growth, debt levels, and cash flow. Investors should also consider diluted EPS to understand the full impact of potential share dilution on earnings.

By understanding EPS in the context of broader financial analysis, investors and analysts can make more informed decisions about a company's performance and future prospects.