EPS is a financial metric used by investors to estimate the value of a given company or its stock.
A company’s EPS is determined by dividing its net profit by the number of common shares it has outstanding. The higher the EPS, the more money a company has made on a per-share basis. The more money a company makes per share, the more attractive their shares may be to investors.
EPS is best used to monitor changes in the profitability of a company over time, or to compare the profitability of two or more companies within the same industry. EPS should always be assessed relative to a company’s stock price and used in combination with other financial metrics.
EPS Formula
A company’s EPS is calculated by dividing its net profit by the number of common shares it has outstanding. Companies typically list EPS and diluted EPS on their income statement. While these two measures are similar, they include some important differences that investors need to be aware of.
Basic EPS
EPS = Net Profit – Preferred Dividends / End-of-Period Common Shares Outstanding.
A company’s net profit is determined by subtracting all cash and non-cash expenses for its revenue for a given reporting period. Preferred dividends are also subtracted to capture payments the company is obligated to make to preferred stockholders before making any additional payments to common stockholders.
Diluted EPS
Companies often use convertible debt to raise capital and offer employees stock options to provide additional incentives to workers. If lenders choose to convert their loans into stocks, and employees exercise their stock options, the company would be required to issue additional shares – thereby increasing the total number of shares outstanding.
Diluted EPS takes this into account and divides the company’s net profit by the number of shares currently existing, plus the number of additional shares the company may be obligated to issue in the future.
Diluted EPS = Net Profit – Preferred Dividends / End-of-Period Common Shares Outstanding + Diluted Shares.
In essence, diluted EPS acknowledges that a company issuing additional shares to address convertible debt or employee stock options would ‘dilute’ the per share value of a company’s stock. As a result, diluted EPS is often considered a more comprehensive metric and a better indicator of a company’s potential value. Because it uses a larger denominator, a company’s diluted EPS will usually be lower (and never higher) than a company’s basic EPS.
Difference in Calculation Method
EPS is used to determine how much money a company makes for each share of its stock. While EPS only considers the number of existing shares available, diluted EPS considers the total number of shares that could be available if convertible debt and employee stock options were exercised in the future.
The examples below will help you appreciate the difference in how EPS and diluted EPS are calculated and what they can tell you about a company’s value.
Examples
Company ABC had $12 million in net profit over the past year, paid out $2 million in dividends, and has 5 million common shares outstanding.
The resulting EPS for Company ABC is:
($12,000,000 - $2,000,000) / 5,000,000 = $2 per share
In addition to its 5 million shares outstanding, ABC employee stock options could be converted to 1 million additional common shares and its convertible debt could be converted to another 1 million common shares.
The resulting diluted EPS for Company ABC is thus:
($12,000,000 - $2,000,000) / (5,000,000 + 1,000,000 + 1,000,000) = $ 1.43 per share
Because Company ABC has dilutive securities in the form of employee stock options and convertible debt, its diluted EPS is less than its basic EPS.
