Earnings per share definition
/What is Earnings per Share?
Earnings per share represents that portion of company income that is available to the holders of its common stock. The measure is closely monitored by investors, who use it to estimate the performance of a business. Investors may elect to acquire or sell a company’s shares based in part on its reported earnings per share figure.
How to Calculate Earnings per Share
The formula for earnings per share is a company's net income minus any dividends on preferred shares, divided by the number of common shares outstanding. The number of shares outstanding is commonly expressed as the weighted average number of shares outstanding over the reporting period. The formula is:
(Net income - Preferred stock dividends) ÷ Number of common shares outstanding = Earnings per share
Related AccountingTools Course
Accounting for Earnings per Share
Example of Earnings per Share
A business reports $100,000 of net income. The entity also issued $20,000 as a dividend to the holders of its preferred stock. The weighted average number of common shares outstanding during the period was 1,000,000. The calculation of its earnings per share is as follows:
($100,000 Net income - $20,000 Preferred dividends) ÷ 1,000,000 Common shares outstanding
= $0.08 earnings per share
The earnings per share concept can be expanded upon to also calculate the percentage change in earnings per share over time, which gives investors a better view of how they are trending. The measure is also useful for comparing the results of businesses that are of different sizes, since their results are reduced down to a common measure.
Diluted Earnings per Share
Diluted earnings per share expands on the basic earnings per share concept by also including the effects of the conversion of convertible instruments and outstanding stock warrants (which reduces the amount of earnings per share). If a business has issued a large number of these convertible instruments, the amount of diluted earnings per share could be substantially less than the basic earnings per share figure.
Problems with Earnings per Share
The earnings per share concept has several inherent limitations and potential problems that can mislead investors and analysts. These issues can stem from the way it is calculated, its reliance on accounting choices, and its potential misuse. Below are the primary problems associated with earnings per share:
Lack of comparability. Companies may use different accounting methods (e.g., depreciation, inventory valuation), which can result in incomparable EPS figures across firms.
Can be manipulated. Companies can inflate or deflate earnings through accounting techniques like deferring expenses or recognizing revenue prematurely, thereby distorting earnings per share.
Ignores capital structure changes. Companies can artificially increase earnings per share by reducing the number of shares outstanding through buybacks, without actually improving underlying business performance. Also, earnings per share can be diluted when employees exercise stock options or when convertible securities are converted into shares.
Does not portray cash flow. Earnings per share is based on accounting earnings, not cash flow. A company may have strong earnings per share but poor cash flow, which can signal financial difficulties that earnings per share alone does not reveal.
Focus on short-term performance. Earnings per share emphasizes short-term profitability and may incentivize management to prioritize actions that boost it in the short term (e.g., cost-cutting or underinvestment) at the expense of long-term value creation.
Ignores debt and risk. Earnings per share does not account for financial leverage or the associated risk. A company with high earnings but excessive debt might have a higher earnings per share figure but be riskier than a company with lower earnings per share and a strong balance sheet.
Overemphasis on valuation. Investors often use earnings per share as a key metric in valuation ratios (e.g., P/E ratio), but this can lead to over-reliance on it, ignoring other critical factors like revenue growth, margins, or cash flow.
While earnings per share is a widely used financial metric, its limitations require investors to view it in context and alongside other financial data. To mitigate these issues, analysts often focus on adjusted earnings per share, which excludes non-recurring items, and complement it with metrics like cash flow per share, return on equity, and debt ratios for a fuller picture of financial performance.