There are a number of methods used by analysts to understand the fundamentals of a firm. Earnings per share (EPS) is one such important tool that is used worldwide to calculate the profitability of a firm. A high EPS generally indicates a high-value company. This means that the investors are willing to pay more for a company's share if the profit is higher.
There are two kinds of EPS. The first is the basic EPS and the second is diluted EPS. While the basic EPS takes in account the outstanding shares of a firm, the diluted EPS includes all convertible shares like ESOPs, convertible bonds, etc.
This measures the profitability of a firm on a per share basis but does not account for the convertible options. It is calculated by this formula: Basic EPS = (Net income – Preferred dividend) / Outstanding common shares.
You take the net income of a firm and subtract the preferred dividends and then divide the result by the total outstanding shares of the firm.
Suppose the firm has a net income of ₹100 crore but did not pay any dividends. It has 10 crore shares listed. Then the EPS will be ₹10.
(100,00,00,000-0)/10,00,00,000 = 10
EPS is important because it helps in the calculation of the price to earnings ratio of a stock which is an essential metric to determine if the stock is overvalued or undervalued by the market.
For a long time, companies were not asked to report their diluted EPS, however, since a number of times companies dilute their stock, it has now become an important tool for technical analysis. Convertible securities include convertible debentures, convertible debt, convertible shares, employee equity options like ESOPs and warrants.
All these dilutions are calculated by the diluted EPS, which gives a clearer picture of its earnings per share.
To calculate diluted EPS, the company’s net income and subtract preferred dividends, then the result is divided by the sum of the outstanding shares and dilutive shares.
Diluted EPS = (Net income - preferred dividend)/ All convertible securities plus common shares.
Suppose a firm has 10 crore shares and employee options that can be converted to another 1 crore shares and convertible debentures which can be converted to 4 crore shares. The company's net income is ₹100 crore and has not paid any dividends. Then the diluted EPS will be ₹6.66 per share.
(100,00,00,000-0)/15,00,00,000 = 6.66
For fundamental analysis, diluted EPS is more accurate and shows a clearer picture of the company. This ensures the company’s EPS is in line with future expansion. If there is no significant dilution in a company, basic EPS can serve the same purpose.
Calculating the P/E ratio with a diluted EPS gives a more realistic view of the firm.
Here's how you can use the EPS:
- It could help you understand the profitability of a company which in turn can impact dividends and stock price.
- It helps calculate the price to earnings ratio (P/E ratio) of the firm, which measures its stock price relative to its EPS.
- You can check past performances and see if the firm's EPS is growing or declining over time.
- you can also compare the company's EPS to analysts' expectations. If it beats the forecast, it shows more growth potential
- You can also use it to choose between 2 or more firms from the same sector.
Both basic and diluted EPS helps understand the fundamentals of a firm. Now that we know the difference, we can use it to better understand a company's financial health.