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Earnings per Share - Measuring the Economic Value of a Stock

Financial analysts use Earnings per Share as a way to determine the relative corporate value of a stock. The dividends declared on preferred stock are subtracted from Net income, and this number is then divided by Weighted Average number of Outstanding Common shares & its equivalents. Earnings per Share is very commonly used by the media to evaluate the value of a stock, e.g. if you go to Google Finance, you will see EPS in the summary of a stock along with other measurements such as Price to Earnings ratio, dividend yield, low & high range of a stock, 52 week trading high, etc.

The two most commonly used formulas for calculating Earnings per share include:

i) Earnings Per Share

 Net Income - Preferred Stock Dividends Weighted Average # of Common Shares & Equivalents

or

ii) Fully Diluted EPS

 Net Income - Preferred Stock Dividends # of Outstanding Common Shares & Common Share Equivalents

The 2nd formula where the denominator is # of Common Shares Outstanding & Common Share Equivalents is known as the Fully Diluted EPS. It is 'fully diluted' because all convertible bonds, preferred stock, convertible warrants and stock warrants & rights are included in the calculation.

How EPS is Calculated

Earnings per share is a way of standardizing a company's net income left over for shareholders across all companies. For instance, two Companies A & B could earn \$10 million a year, but

Company A has 50,000 shares outstanding while Company B has 500,000 shares outstanding. So how would you normalize earnings per share across these two companies?

 Company A = \$10 million / 50,000 shares = \$200 / share

 Company B = \$10 million / 500,000 shares = \$20 / share

Many financial advisors feel Earnings per Share is not a good way to determine economic value of a stock because of the following reasons:

1) Business & financial risks of corporations is not measured by EPS because it is just a reported net income number; it does not provide any further information that can be found in media reports or prospectus of a company.

2) Dividend policies are not factored in to EPS and any decreases in dividends will result in a higher Net Income, thus a higher earnings per share number, which is actually detrimental to the value of a stock.

3) Earnings per Share does not factor in time value of money as this finance concept is not reflected in the EPS number produced on financial statements.

4) Corporate finance activities such as share buybacks increase the EPS as the # of shares outstanding on the capital markets is reduced; this is one strategy a corporation could use to improve its Earnings per Share number to investors.

When a company earns profits, it can either give back to shareholders in i) below or it can put the money in to retained earnings and re-invest in to the company to expand operations, capture new market share, hire employees or buy plant & equipment, etc.

i) Pay stock dividends to shareholders every quarter, and usually based on the dividend yield.
Financial managers report Earnings per Share in 3 different formats, all of which you should be aware of:

1) Trailing EPS - Current net income divided by the # of shares outstanding

2 Current EPS - This year's estimated net income before year-end divided by # of shares outstanding

3) Forward EPS - Estimate of future net income divided by # of current shares outstanding. This is a future projection of earnings per share.