Earning Per Share (EPS) – Explanation,Importance and Limitation
What is Earning Per Share (EPS)?
Earning per share or EPS is the portion of a company’s profit that is allocated to each outstanding stocks. EPS is calculated by dividing the net profit for a particular quarter by the total number of outstanding shares in the market.Example:- Suppose a company “A” has posted a net profit of Rs-1,000 for a particular year. It has total of 100 shares. So, its earning per share will be 10 (1,000/100). A company reports its earning per share in each quarter. So.you can easily get this figure from the quarterly result. Normally Earning per share is calculated based on the last 12 months.So,it refers TTM(Trailing twelve months) EPS. You will find most of the financial websites represent the figure in the form of EPS(TTM).
When does earning per share increase?
- From the definition of earning per share it is very clear that EPS can increase if the net profit of the company increases. But it may not true always. Earning per share can increase even if the profit remains flat or even goes down. Consider the next case.
- If a company has gone through a buy-back program then also EPS can increase. Buy-back program is to buy company’s own shares by its promoters itself. Due to share buy-back program the total number of outstanding shares decreases. As a result earning per share increase. Suppose the company “A” that we have mentioned earlier saw its profit dipping to Rs-950. But its total number of shares went down to 90 due to buy-back. Hence the EPS would go up to 10.55.(950/90).
In case of merger or acquisition total number of outstanding shares may decrease that could also lead to an increase of earning per share.
When does earning per share go down?
- From the definition, Earning per share can go down if the profit falls. But again it may not true always. Earning per share can also go down even if the company increases its profitability. Consider the following case.
- Follow-on public offer or an activity to raise fresh capital increase the number of outstanding shares. In this case even if the net profit rise,Earning per share can go down. Let’s look at the company “A” again. Suppose its profit goes up to Rs-1,100. It also raised its total number of shares to 120. So the EPS will go down to 9.16 per share(1,100/120).
Importance of Earning per share:-
Earning per share is a very important figure. It reveals a lot about the financial health of a company. Increasing EPS is a very good sign for a particular company. EPS tells you how much profit a company earns from a single stock available in the market. So, as an investor you must keep a close look at the EPS of the company in its every quarterly result.
Limitations of EPS:-
- Although EPS is an important number to note. At the same time, it should not be the only figure to drive your decision. EPS,alone won’t tell you the entire story. You have to keep a close look on the P.E ratio (price to earning ratio) to get more clear picture. Click here to know more about P.E ratio,its significance and importance from an investor’s point of view.
- A company can easily manipulate its reported profit. So,EPS can also be easily distorted. For this reason you should always invest in a company which has clean and clear corporate governance along with an honest and experienced management.
Conclusion- What should you do?
As I stated earlier, don’t consider Earning per share in an isolation. Look at the P.E ratio while you are figuring EPS. If you own a stock whose EPS has fallen,you should not be in a hurry to exit.Similarly,don’t invest in a stock just because its earning per share is increasing. Find the proper reason of falling/rising of EPS.
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