Understanding Earnings Per Share (EPS)

Earnings Per Share (EPS) is a fundamental measure of a company's profitability on a per-share basis. It's the "E" in the P/E ratio and one of the most watched metrics in investing. [DEFINITION] Earnings Per Share (EPS): A company's net income divided by its outstanding shares, representing the profit allocated to each share of common stock. [FORMULA] Basic EPS = Net Income ÷ Weighted Average Shares Outstanding ### Why EPS Matters EPS allows comparison between companies of different sizes: [EXAMPLE] Two companies: | Metric | Company A | Company B | |--------|-----------|-----------| | Net Income | $1 billion | $100 million | | Shares Outstanding | 1 billion | 50 million | | EPS | $1.00 | $2.00 | Company A is larger, but Company B earns more per share. As a shareholder, B is more profitable per share you own. ### Types of EPS **Basic EPS:** Uses actual shares outstanding. Simple and straightforward. **Diluted EPS:** Assumes all stock options, warrants, and convertible securities are converted to common stock. Shows "worst case" EPS. [TIP] Always look at diluted EPS for a conservative view. Tech companies with heavy stock compensation can have meaningful dilution. [EXAMPLE] Netflix: - Basic EPS: $12.50 - Diluted EPS: $11.80 The 70-cent difference reflects shares that would be issued if all employee options were exercised. ### EPS Growth: The Key to Value Creation Consistently growing EPS drives stock prices higher: [KEY] Over long periods, stock prices tend to track EPS growth. A company growing EPS at 15% annually will likely see its stock price grow similarly. **Microsoft EPS History:** - 2014: $2.63 - 2019: $5.76 (119% increase) - 2024: $11.50+ (100% increase from 2019) Stock price followed, rising from ~$40 to $400+ over this period. ### GAAP vs. Non-GAAP EPS [DEFINITION] GAAP EPS: Earnings calculated using Generally Accepted Accounting Principles—the official standard. [DEFINITION] Non-GAAP EPS: "Adjusted" earnings excluding certain items like stock compensation, restructuring charges, or acquisition costs. [WARNING] Companies often highlight non-GAAP EPS because it's higher. Be skeptical: - Stock compensation is a real cost - "One-time" charges shouldn't appear every year - Compare both metrics over time [EXAMPLE] Company reports: - GAAP EPS: $2.00 - Non-GAAP EPS: $3.50 (excludes $1.50 in stock compensation) The stock compensation is real—employees received value. The true earnings picture is closer to $2.00. ### Earnings Beats and Misses Wall Street analysts estimate EPS each quarter. The actual result vs. estimate moves stocks: | Result | Stock Reaction | |--------|----------------| | Beat by 10%+ | Often jumps 5-15% | | Beat by 1-5% | Usually positive | | In-line | Mixed reaction | | Miss by 1-5% | Usually negative | | Miss by 10%+ | Often drops 5-20% | [TIP] The guidance matters as much as the beat. A company can beat estimates but fall if they lower future guidance. Focus on the full picture. ### Quality of Earnings Not all EPS is created equal: **High-Quality Earnings:** - Backed by cash flow - From core operations - Sustainable and repeatable **Low-Quality Earnings:** - One-time gains (selling assets) - Aggressive revenue recognition - Reduced R&D or marketing (cutting corners) [EXERCISE] A company reports Net Income of $500M. They have 100 million basic shares and 110 million diluted shares outstanding. Calculate both Basic and Diluted EPS. |ANSWER| Basic EPS = $500M ÷ 100M = $5.00. Diluted EPS = $500M ÷ 110M = $4.55. The 9% difference shows meaningful potential dilution from convertible securities. ### EPS and Buybacks Companies buying back shares reduce shares outstanding, boosting EPS: [EXAMPLE] Year 1: $100M earnings ÷ 20M shares = $5.00 EPS Year 2: $100M earnings ÷ 18M shares = $5.56 EPS (11% higher) Same earnings, but EPS grew because there are fewer shares. This is why buybacks are popular—they boost EPS without improving the actual business. [SCENARIO] A company reports EPS of $5.00, beating estimates of $4.80. But operating cash flow is only $3.00 per share. Investigation reveals they cut R&D spending by 30% and delayed necessary equipment purchases to hit the number. This is low-quality earnings—they've borrowed from the future to beat estimates today. Be skeptical when EPS consistently exceeds cash flow.