Discover the meaning of earnings per share.
- An individual shareholder is interested in how much of a company's net income is associated with his or her ownership interest. As a result, the income statement reports earnings per share, or EPS, which is the amount of net income associated with each common share of stock. To illustrate the importance of earnings per share, consider the following example: for the years 2018 through 2020, Jame Caird Company had net income, average shares outstanding, and earnings per share as follows.
Now note that if one looks only at the growth and net income, it appears that shareholders of James Caird are doing very well, with net income growth rates of 140% in 2019 and 67% in 2020. However, a look at the data on shares outstanding reveals that this growth in net income has been driven by a substantial increase in the size of the company, as evidenced by the large increases in shares outstanding.
When viewed on a per share basis, performance was actually steadily declining from 2018 to 2020. One of the original shareholders who earned $2.50 for each share owned in 2018, earned only a dollar per share for each of those same shares in 2020. Companies often disclose two earnings per share numbers. Basic EPS reports earnings based solely on shares actually outstanding during the year.
Basic earnings per share is computed by dividing income available to common shareholders, that's net income, less dividends paid to or promised to preferred shareholders, by the average number of common shares outstanding during the period. Now, diluted earnings per share reflects the existence of stock options, or other rights that can be converted into shares in the future. For example, in addition to having shares outstanding, a company can also have granted stock options, that allow option holders to buy shares of stock at some pre-determined price.
At present, the option holder don't own shares of stock, but they can acquire them from the company at any time. In other cases, a company might borrow money, but also give the right to the lender to exchange the loan for shares of stock at some pre-determined price. Diluted earnings per share is computed to give financial statement users an idea about the potential impact on EPS of the exercise of existing options or other rights to acquire shares.
Earnings per share is often used to calculate a firm's price-earnings, or PE, ratio. This ratio expresses the market value of common stock as a multiple of earnings, and allows investors to evaluate the attractiveness of a firm's common stock. This ratio measures the relationship between the market value of a company, and that company's current earnings. The price-earnings ratio is computed by dividing the market price per share of common stock by the annual basic EPS.
The Wall Street Journal reports PE ratios for most listed companies on a daily basis. Now in the United States, PE ratios typically rank from five to 30, high PE ratios are associated with firms for which strong growth is predicted in the future. For example, Alphabet, the parent company of Google, has a high PE ratio, about 51 in September of 2018, but it is not found on the list of companies with high net income. The reason Google is valued so highly, is that it is expected to continue to grow so rapidly in the future, that it's current income is small compared with what investors are expecting.
Earnings per share information tells the owner of a single share of stock, how much of the net income for the year belongs to him or her. This EPS information is also used by the market to give some indication of the future expected for the company. This indication is summarized in the PE ratio, which is reported by the Wall Street Journal, every single day.
Stay tuned for Part 2 of the training series, which covers ratio analysis, forecasting, and business valuation.
- Explain the equality required in the basic accounting equation.
- Recall why accounts payable are considered Current Liabilities.
- Identify which financial statement can be described as a “snapshot” of a company’s final position.
- Name the term used to refer to a company where the Operating Cash exceeds the investing and Financing activities.
- Identify the result of entering a debit in an expense account.
- Name the account that is closed at the end of the year.