Earnings Per Share - Explained
What are Earnings Per Share?
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Table of ContentsWhat are Earnings Per Share?How to Calculate a Company's Earnings Per Share?Basic Earnings Per ShareDiluted EPSAcademic Research on Earnings Per Share
What are Earnings Per Share?
Earnings per share (EPS) is an accounting measure. It is calculated by deducting preferred dividends from net income and then dividing that number of outstanding common shares. Preferred shareholders receive preferential payments before common shareholders are paid. When calculating the earnings per share, you are calculating the earnings per share of common stock.
- Note: Most publicly traded companies do not have preferred shares, pursuant to SEC regulations or exchange rules.
Investors who want to invest in equity are interested in company's EPS. The EPS is an indication of a company's profitability. The higher the Earning per Share (EPS), the more equity holders will benefit.
How to Calculate a Company's Earnings Per Share?
To calculate the EPS of any company, one needs to extract data from balance sheet and income statement. Lets look at how to calculate the Basic Earnings Per Share and the Diluted Earnings Per Share amounts.
Basic Earnings Per Share
Begin with the income statement. Identify the net income of the company over the relevant fiscal period. Next, determined the amount of preferred dividends paid. This figure can be found on the income statement. You will deduct this amount from the net income figure. Then, identify the weighted average common shares of the company. The weighted average is used, as the number of outstanding company shares will fluctuate over the fiscal period being measured. The number of outstanding shares varies due to stock plans, issuance of new shares, repurchases of shares, and so on. Alternatively, EPS can be calculated by using the number of shares outstanding but the result will not be more accurate. The total or weighted average number of shares can be calculated from balance sheet and income statement. Lastly, divide the net income minute preferred share payments by the weighted average common shares to arrive at the Earnings Per Share amount.
The Basic Earnings per Share uses a simplified capital structure when calculating the EPS. Diluted Earnings per Share (EPS) is slightly more complicated. It requires one to consider warrants, preferred stocks, convertible bonds, and stock options in calculating the total outstanding common shares. These types of instruments are included, as they can be converted into common stock at some point in the future (if so desired). Using the diluted securities figure for outstanding share will generally increase the total number of outstanding shares and hence the earning per share (EPS) declines.
Academic Research on Earnings Per Share
- Corporate forecasts ofearnings per shareand stock price behavior: Empirical test, Patell, J. M. (1976). Journal of accounting research, 246-276. The aim of the study is to sample the hypothesized information content of company predictions through the observation of the stock price behavior of 336 predictions between 1963-1967. The outcome of the investigation showed that the predictions were followed by large price changes. The author concluded that data showcased in management forecasts communicate information to investors.
- Stock market reaction to estimates ofearnings per shareby company officials, Foster, G. (1973). Journal of Accounting Research, 25-37. This article studies the stock market reaction to possible information generating events such as values of yearly Earnings per share (EPS) by company officials. These values are gotten at the end of the business year, but before the audited earnings are released.
- Forecasts ofearnings per share: Possible sources of analyst superiority and bias, AFFLECKGRAVES, J. O. H. N., Davis, L. R., & Mendenhall, R. R. (1990). Contemporary Accounting Research,6(2), 501-517. Two reasons for the superiority of analysts' forecast have been established in existing studies. This article supplies proof of a potential third reason for the superiority of analysts' forecasts. The third reason is that humans are able to use data of past earnings to foretell future earnings more precisely than automated time models. Research has shown that these predictions are sometimes biased because of the use of human experience or trial and error methods.
- Economic value added, future accountingearnings, and financial analysts'earnings per shareforecasts, Machuga, S. M., Pfeiffer, R. J., & Verma, K. (2002). Review of Quantitative Finance and Accounting,18(1), 59-73. Existing studies on the effectiveness of Earnings Per Share and Economic Value Added (EVA) as a technique for high performance of stock valuation has varied. This paper main purpose is to investigate the role of EVA and EPS in improving the accuracy and effectiveness of analysts' forecast. The results of the studies showed that EVA holds information that adds to EPS prediction potential. From the results, we also observed that analysts do not utilize the information in EVA properly, rather they overweigh it.
- Earningsmanagement through transaction structuring: Contingent convertible debt and dilutedearnings per share, Marquardt, C., & Wiedman, C. (2005). Journal of Accounting Research,43(2), 205-243. This paper studies whether companies construct their convertible bond transactions to be able to handle diluted Earnings per share (EPS). The authors note that the use of compensation contracts based on EPS affects the chances of issuing Contingent Convertible bonds (COCOs) by a firm. This article provides proof, though weak, that reputation costs have a part to play in the construction of convertible bond transactions.
- Impact ofEarnings per shareon Market Value of an equityshare: An Empirical study in Indian Capital Market., Pushpa Bhatt, P., & Sumangala, J. K. (2012Journal of Finance, Accounting & Management,3(2). Equity valuation is an important question in which scholars and researchers in the area of Capital markets have been trying to answer. Different accounting terns have been used to define equity return and equity value. This paper investigates the effect of Earnings per share (EPS) on the value of an equity share in the Indian Capital market. The study was carried out in 5 years using data obtained from the top 50 most valuable companies in India according to the Business Today Survey of 2010. The authors concluded that EPS affects the value of an equity share in the Indian market.
- Segmentearningsdisclosure and the ability of security analysts to forecastearnings per share, Baldwin, B. A. (1984Accounting Review, 376-389. Existing studies have established that time-series models give better forecasts of future earnings with the use of segmented data. This paper used the analysts' forecasts to determine whether humans are also able to use segmented data to increase the accuracy of their predictions. Data were obtained from three groups of companies: multi-segment companies that revealed segment earnings before 1971, multi-segment companies that disclosed segment earnings in 1971 and single-segment companies that reported earnings together. The results showed reduced error in mean and variance of predictions for all groups.
- Executives' forecasts ofearnings per shareversus forecasts of naive models, Copeland, R. M., & Marioni, R. J. (1972).Journal of Business, 497-512. The two articles published by Green and Segall about the predictive power of 1st quarter earnings received a lot of criticisms and comments. This led the authors of this paper to question the legitimacy of their study. They questioned Green and Segalls article for the following reasons: firstly, the forecasts they sampled was too small. Secondly, the samples tested were not representative. And finally, the years selected for sampling were not representative.
- Additional evidence on the time series properties of reportedearnings per share: Comment, Salamon, G. L., & Smith, E. D. (1977) The Journal of Finance,32(5), 1795-1801. The main purpose of this article is to provide proof of the importance of ex-post sample selection bias used by Balls and Watts against income reduction. The second purpose of the article is to provide data that shows evidence that there is more diversity than similarity in some of the characteristics of the earning process of different firms.
- An empirical study on the impact ofearnings per shareon stock prices of a listed bank in Malaysia, Seetharaman, A., & Raj, J. R. (2011). The International Journal of Applied Economics and Finance,5(2), 114-126. Earnings per share (EPS) is a major investment tool used to estimate a companys long or short-term performance. In this article, an investigation was carried out on a bank in Malaysia, the Public Bank Berhad (PBB). Data of about 19 years were observed to detect a relationship between the banks EPS and its stock price. Results show that the EPS had a strong positive effect on PBBs stock price.
- Analysts' use of information about permanent and transitoryearningscomponents in forecasting annualEPS, Ali, A., Klein, A., & Rosenfeld, J. (1992). x, Accounting Review, 183-198. This article answered the question of whether analysts were able to predict prospective earnings with foreknowledge of the differences in the temporary and permanent components of the previous year's earnings. In the course of the study, the authors also discovered that overestimation in predictions is more common in companies that recently experienced poor earnings while favorable serial correlation was experienced by firms with permanent earnings.