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Make Sense of Earnings Per Share

by Amy Buttell / April 18th, 2011

You hear about them on the financial news, where their quarterly reporting seems to make or break a company's stock performance. Just what exactly are earnings per share (EPS), and how does EPS influence the performance of a company's stock? At the most basic level, EPS is a company's earnings during a particular period, divided among the company's shares outstanding. It is expressed as a dollar figure and can be positive or negative. Professional stock analysts spend a lot of time attempting to estimate future EPS based on a variety of sources. If a company exceeds analysts' estimates, its stock is likely to rise in the short term, just as it is most likely to fall if actual EPS is below these estimated figures. For the growth stock investor, EPS is an important figure. It pays to be aware of exactly what EPS means and how analysts and individual investors figure out their estimates of future earnings.

Defining EPS

As indicated, EPS is a company's earnings or net income divided by its shares outstanding. Net income is the amount of profit earned by a company after it pays taxes and regular operating expenses. Shares outstanding are the average number of shares outstanding issued by a company during a particular period. Here's an example. XYZ Company has quarterly earnings or net income of $4 million with 13.2 million shares outstanding. Dividing the earnings by the shares outstanding works out like this:
$4 million ÷ 13.2 million = .3003
Rounding the EPS figure, as is commonly done, gives us a figure of 30 cents a share. U.S.-based publicly held companies are required to file financial statements four times a year with the Securities and Exchange Commission (SEC), Washington, D.C., which is why you hear about "quarterly" earnings in the financial press. The most common reporting schedule is at the end of March, June, September, and December, but companies can report on a different schedule as long as the reporting periods are even and regular. Companies are also required to report yearly financial statements at the end of their fiscal year, which is why you hear about "yearly" earnings per share.

Varieties of earnings

As straightforward as the calculation seems, there are types of EPS, and those varieties can complicate your assessment of a company's prospects. This complexity is found in both the variables that make up the EPS equation.
Investors and professional analysts prefer diluted EPS because it is a more conservative figure than primary EPS.
First, let's talk about the top figure in the EPS equation—earnings. As we've mentioned, earnings are based on net income from a particular period. That period can be quarterly, yearly, or even six months (two quarters). It can be from the past, or projected—or estimated—from the future. EPS can also vary based on the particular accounting policies or financial assumptions of the reporting company. Although a company has to comply with certain assumptions in reporting its EPS to the SEC, it can issue other EPS figures that make it look better to the public through press releases and earnings announcements. A company must report EPS based on generally accepted accounting principles (GAAP) in its SEC filings. This is a generally conservative number accepted by the government and accounting professionals. Outside of GAAP earnings, a company can report its earnings in a number of other ways. It could exclude one-time events that aren't likely to happen again or include revenues that aren't included in GAAP earnings. And these are just some of the ways that the earnings part of the equation can vary. It gets even more interesting once you factor in all the ways shares outstanding can be calculated.

Shares outstanding

Like earnings, shares outstanding is a fluid figure that can be calculated in several ways. Generally, an average of the number of outstanding shares for a particular period that are currently in the market available for trading is used in the EPS figure. When this figure of shares outstanding is used, EPS is known as "primary" EPS. Although this would seem the easiest route to take in calculating EPS, it can seriously understate the number of shares potentially available, leading to an overstatement in EPS for a particular period. If you think EPS is higher than it actually is, you may accord a certain value to a company that may not be there. That's one reason why it's important to understand the variables involved in calculating EPS. This second way of calculating the potential number of shares outstanding is known as "diluted" EPS. It includes all the shares that would be outstanding if stock options and warrants were converted to actual shares at a certain time.
Long-term investors focus on how a company performs during a number of years.
Stock options and warrants allow their holders to purchase stock in a company at a certain price and at a certain time. Stock options are widely used to reward company executives and employees for superior stock price performance. When examining EPS, investors and professional analysts prefer diluted EPS because it's a more conservative figure than primary EPS. Some companies that don't use stock options or that expense them in certain ways might have primary and diluted EPS that are the same figure.

Estimating EPS

Now what's the big deal about analysts' estimates? Actually, they aren't a big deal. Professional analysts are focused on the short term and how companies perform in a three- or six-month period. Long-term investors focus on how a company performs during a number of years. Although consistent, strong performance is preferred, occasional fluctuations in quarterly earnings based on short-term factors aren't important. In fact, many growth-oriented long-term investors seize buying opportunities in a particular company's stock if it fails to meet analysts' estimates. A company's stock price may fall if EPS is up 18% where analysts expected 20%. The long-term investor realizes that an 18% increase in EPS is still a solid number, regardless of the expectations of professional analysts.

The bottom line

Like many financial numbers, EPS can be complicated. The most important factor is to be aware of the types of EPS and the reliability (or lack thereof) of analysts' estimates.
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This article was originally published by BetterInvesting. Since 1951, BetterInvesting has helped more than five million people become better, more informed investors. BetterInvesting helps its members build wealth through educational webinars, Web-based mutual fund and stock tools, in-person learning events, publications, an active online community, and software. For more information, visit the website or call 877-275-6242. Neither CUNA nor the author of this article is a registered investment adviser. Readers should seek independent professional advice before making investment decisions.
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