ROA, ROE, ROI, PE, EPS… Welcome to the world of financial accounting ratios. Confusing for some and comforting for others, these tools can be highly effective in making investment decisions. Given their simplicity, a number-averse person too can use them. Significant amongst the lot is the concept of earning per share (EPS). Companies are required to report both, the basic and the diluted EPS in their financial reports.
What is EPS?EPS is a measure to track the profitability and success of a company on a per share basis. It is a significant determinant of the price of a share. Mathematically EPS is the net profit or loss, less preference share dividends, divided by the weighted average number of shares outstanding during a period. The number of outstanding shares could vary owing to the company buying back shares, issuing fresh equity, conversion of debt to equity, etc.
At the same time a company often has other financial instruments floating in the market that could be converted into equity. This potentially convertible equity could dilute your holdings. In order to take these into account, the concept of diluted EPS emerged. The two quoted figures can be quite different and you need to know what your share in the earnings will stand at if all the options of dilution come into effect. Companies report trailing EPS which is the based on earnings of the past year. You will often come across terms such as current and forward EPS, these figures are based on estimated earnings of a company
How do you use it?Just the way an investment decision made solely on the price of a stock or NAV of a mutual fund, is deficient, stand alone EPS bears no meaning. It is used, primarily as a tool for comparison. At the same time you can't compare the EPS of companies functioning in different industries. In making an investment decision, one can analyse the rate of change in EPS in the last two quarters and compare this change to the EPS growth rates in the past three to five years. This would indicate if the company is on track in the current fiscal. As a tool for inter firm comparison, EPS gives you an indication of the return on investment made.
LimitationEPS does not take into account the market price of a stock and its use is limited to gauging the earning consistency of the company. When analysing EPS you must also look at the price earning ratio as well.
