Earnings Per Share (EPS)
Where;
Net Profit after Tax (PAT) is the earnings the business has generated at the end of the financial year net of two things
1. Taxation
2. Preference shareholder Dividends (proposed and paid(i.e. interim))
Total ordinary share capital is the total number of ordinary shares issue and fully paid
Types of Earnings Per Share (EPS)
The types of EPS is based on the criteria of expected value addition changes on the number of common stock or outstanding ordinary shares. In this case, we have two categories
1. Basic EPS
2. Weighted EPS
Steps of Computing Basic EPS
STEP 1: Compute the net profit after tax
STEP 2: Establish the exact number of ordinary shares as per balance sheet end of year dates
STEP 3: Compute Basic EPS value using this formula
Illustration & Examples
Illustration
Given the following
Profit After Tax is $10,000,000
Outstanding common stock 2,000,000
Required,
Determine EPS
Solution
EPS= $5
Steps of Computing Weighted EPS
Weighted EPS is more reliable because it factors in any changes in the course of the year that can change the TRUE number of outstanding ordinary shares or changes true value of the current EPS. For example conversion of preference shares and bonds in to ordinary shares, bonus issue etc. so the steps of determining WEPS is slightly different to the one for basic EPS as shown below;
STEP 1: Compute the net profit after tax
STEP 2: Compute the amount of preference dividends proposed and paid
STEP 3: Compute the PAT less Preference Dividend.
STEP 4: Establish the exact number of ordinary shares as per balance sheet end of year dates
NB: If there are any equivalent ordinary stocks to be determined, such as converted bonds or bonus issue or sell of stock to employees at a discount, this should be factored herein
STEP 5: Compute Weighted EPS value using this formula
Example
ABC company had net income $7,500,000 in 2018. The management declared preference dividend of $1,500,000 at the end of the year. The company had outstanding ordinary shares of 2,000,000.
Required
Determine
i) Basic EPS
ii) Weighted EPS
Answer
Market Interpretation of EPS
EPS shows the amount of earnings (returns) that the owners of the company expect to get from every ordinary share they have invested in. For example, an EPS ratio of 0.60 means that for every 1 unit of currency invested in ordinary shares, the business will reward the owners some 0.6 units of the investing currency.
Importance of EPS
EPS shows the earning power of an organization. In other words, it shows the abilities a firm has in generating income. This can be determined may be by the level of its asset tangibility or unique strategic moves which make a firm invest profitably
Why Know the EPS of a Business?
Why is it important as an investor to know the level of a business EPS?
1. Profitability gauge-EPS is the income generating engine like that of a motor vehicle. You see, the bigger the EPS the bigger the engine size of the company. So the EPS guides you whether the firm you harvested in or you intent to invest in can pay good returns
2. Dividend Payouts-EPS gives you a hind the nature of dividends the company may declare at the end of the year. If the EPS is very small or low, chances of being issued with bonus shares (Script issues) is high and if EPS ratio is high, probably cash dividends are sure.
3. Price/Earnings ratio predictor-the investors are in a position to assess the rate at which the changes in the market value of the business has as compared to the earnings power or the income generating power the firm has. This will guide the investors to know their mission why the business exist.
4. EPS is paramount because for the existing investors, they can gauge the worth of their investment. A low level of EPS score implies worthless investment unlike were the rate is at 1.50. in this case it means the returns are promising
Applicability of EPS in Investment Decision Making
EPS perspective is of much applications in decision making. The following are some of the aspects that cut across EPS of a business.
1. Cheap source of finance-EPS portrays the level of financing of the business. Whether purely from owners (internal) or otherwise. If the EPS ratio is a big one, it means most of the earnings of the business are paid to the owners and not external financiers such as bondholders. Therefore, we can conclude that the firm is using the cheapest source of finance (see pecking order theory)
2. Level of income generation of a firm-EPS which is high implies more income generation power the business has hence assurance of market competitiveness
3. Opportunity cost-EPS ratio indicate the forgone benefits by the owners of the business. This is because a higher EPS means that retaining of profits in the business is better than the owners using the same profits to invest elsewhere.
4. Tax shield benefits-EPS ratio which is high means not much external financing of the business. The firm is facing a scenario where no external debt financing which means t cannot take advantage of tax allowable advantages of debt interest expense. On the other if EPS is fairly low, it means the business is also funded by external debt and there is tax shield benefits of debt interest expenses which are tax allowable expenses
Advantages of Earnings per Share (EPS)
Some of the advantages of earnings per share are:
1. Stock pricing tool-EPS dictates the price of the company stocks in the market. The higher the EPS ratio the better the prices.
2. Shows the real worth of the shareholders net worth.
3. Simple to compute and interpret The calculation of EPS is simple and straightforward
4. Performance metric. It is one of the tools to measure company performance. The higher the ratio, the better business the performance.
Disadvantages of Earnings per Share (EPS)
Some of the shortcomings of EPS are:
1. EPS Values can be manipulated-the management can alter the EPS values to convince owners of good performance. i.e cooking of books
2. EPS per se doesn’t capture the performance of the company as it fails take into account the price of the share. EPS along with the share price can be used to check the rate of return.
3. Impossible to value firms with negative EPS. With loss making firms, it becomes a challenge to determine its market value.
Factors Affecting Earnings per Share (EPS) of a Business
1 Company earnings-if profit of the year increase or decrease, EPS change accordingly. N
2 Earnings per share increases when the total number of outstanding share decreases in case of buyback.
3 Operating expenses-if operating expenses decrease, EPS increase and the vice versa is true.
4 New issuance-when new ordinary share capital is raised by issuing new shares. This will increase the denominator base hence EPS will decline
5 Asset Tangibility-AT is the ratio of physical assets to intangible assets and the bigger the ratio the more EPS the firm has.
6 Asset Efficiency- the higher the efficiency the better the EPS
7 Leverage level-if the firm is facing higher level of external debts, the residual amount of earnings after paying the debt obligation may result to reduced EPS and the opposite is true
8 Tax logistics-if the tax regime turns to be favorable to the business, then taxes reduce and in lieu, earnings increase.
9 Act of repurchase of stock-if already issued ordinary shares are bought back, it means that the total outstanding shares has reduced and this leads to increases EPS
