Earnings Per Share (EPS) is a financial metric that represents the portion of a company’s profit allocated to each outstanding share of common stock. It is a widely used indicator of a company’s profitability, and investors often use it to assess the performance of a company and compare it with others in the same industry. EPS is calculated by dividing the net income (or earnings) by the number of outstanding shares of common stock.

Here’s a detailed breakdown of the concept:

1. Net income: This is the company’s total revenue minus its expenses, taxes, and costs. Net income represents the profit that the company has earned over a specific period, usually a quarter or a year.
2. Outstanding shares: These are the total number of shares of common stock that are held by the company’s shareholders. This includes shares held by institutional investors, insiders, and the public. The number of outstanding shares can change over time due to stock buybacks, issuance of new shares, or stock options exercised by employees.

To calculate the Earnings Per Share:

EPS = Net Income / Outstanding Shares

It’s important to note that there are two types of EPS calculations:

1. Basic EPS: This is the simplest form of EPS calculation, which only considers the outstanding shares of common stock. It does not account for any convertible securities, such as convertible preferred shares, convertible bonds, or stock options, that could potentially be converted into common shares.
2. Diluted EPS: This calculation considers the potential dilution that could occur if all convertible securities were exercised or converted into common shares. Diluted EPS usually provides a more conservative estimate of the company’s earnings performance, as it accounts for the potential increase in the number of shares outstanding.

Investors and analysts often use EPS as a tool to evaluate a company’s performance and compare it to industry peers. A higher EPS generally indicates better financial performance, while a lower EPS may signal financial difficulties. However, it is essential to consider the context and other financial metrics when assessing a company’s overall performance and future growth potential.

Let us look at an example:

Two companies Entity GAI and Entity GFE are identical in every respect, with the exception of their capital structure. Both Entities have assets of \$1,000,000, and both have annual profits before interest and tax of \$100,000. However, Entity GAI is an all equity company, with 1,000,000 shares of \$1, and Entity GFE is a 50%-geared company, with 500,000 shares of \$1 and \$500,000 of 8% debt. The rate of taxation is 30%.

Calculate the earnings per share (EPS) of each company.

Solution:

To calculate the Earnings Per Share (EPS) for both companies, we’ll first determine their net income (earnings after interest and taxes) and then divide that by the number of outstanding shares.

1. Profit before interest and tax (PBIT) = \$100,000
2. As GAI has no debt, there is no interest expense.
3. Profit before tax (PBT) = PBIT – Interest = \$100,000 – \$0 = \$100,000
4. Tax = PBT * Tax rate = \$100,000 * 30% = \$30,000
5. Net Income = PBT – Tax = \$100,000 – \$30,000 = \$70,000
6. Outstanding shares = 1,000,000
7. EPS = Net Income / Outstanding shares = \$70,000 / 1,000,000 = \$0.07

Now, let’s calculate EPS for Entity GFE:

1. Profit before interest and tax (PBIT) = \$100,000
2. Interest expense = 8% * \$500,000 = \$40,000
3. Profit before tax (PBT) = PBIT – Interest = \$100,000 – \$40,000 = \$60,000
4. Tax = PBT * Tax rate = \$60,000 * 30% = \$18,000
5. Net Income = PBT – Tax = \$60,000 – \$18,000 = \$42,000
6. Outstanding shares = 500,000
7. EPS = Net Income / Outstanding shares = \$42,000 / 500,000 = \$0.084

Hence, Entity GAI has an EPS of \$0.07, and Entity GFE has an EPS of \$0.084.

Now suppose that the profits before interest and tax increase by 50% to \$150,000. What will be the change in EPS for both companies..

Let’s recalculate the Earnings Per Share (EPS) for both companies with the updated profit before interest and tax (PBIT) of \$150,000.

Entity GAI:

1. New PBIT = \$150,000
2. As GAI has no debt, there is no interest expense.
3. New Profit before tax (PBT) = New PBIT – Interest = \$150,000 – \$0 = \$150,000
4. New Tax = PBT * Tax rate = \$150,000 * 30% = \$45,000
5. New Net Income = PBT – Tax = \$150,000 – \$45,000 = \$105,000
6. Outstanding shares = 1,000,000
7. New EPS = New Net Income / Outstanding shares = \$105,000 / 1,000,000 = \$0.105

Entity GFE:

1. New PBIT = \$150,000
2. Interest expense = 8% * \$500,000 = \$40,000
3. New Profit before tax (PBT) = New PBIT – Interest = \$150,000 – \$40,000 = \$110,000
4. New Tax = PBT * Tax rate = \$110,000 * 30% = \$33,000
5. New Net Income = PBT – Tax = \$110,000 – \$33,000 = \$77,000
6. Outstanding shares = 500,000
7. New EPS = New Net Income / Outstanding shares = \$77,000 / 500,000 = \$0.154

Now let’s calculate the change in EPS for both companies:

Change in EPS for Entity GAI: New EPS – Old EPS = \$0.105 – \$0.07 = \$0.035

Change in EPS for Entity GFE: New EPS – Old EPS = \$0.154 – \$0.084 = \$0.07

So, with a 50% increase in profits before interest and tax, the change in EPS for Entity GAI is \$0.035, and for Entity GFE, it is \$0.07.