Earnings per share (EPS) ratio measures how many dollars of net income have been earned by each share of common stock. It is computed by dividing net income less preferred dividend by the number of shares of common stock outstanding during the period. It is a popular measure of overall profitability of the company and is usually expressed in dollars.
Earnings per share ratio (EPS ratio) is computed by the following formula:
The numerator is the net income available for common stockholders’ (net income less preferred dividend) and the denominator is the average number of shares of common stock outstanding during the year. It does not include preferred shares.
The formula of EPS ratio is similar to the formula of return on common stockholders’ equity ratio except the denominator of EPS ratio formula is the number of average shares of common stock outstanding rather than the average common stockholders’ equity.
Following data has been extracted from the financial statements of Peter Electronics Limited. You are required to compute the earnings per share ratio of the company for the year 2016.
Net income for the year 2016: $1,500,000
6% cumulative preferred stock outstanding on December 31, 2016: $3,000,000
$15 par value common stock outstanding on December 31, 2016: $2,376,000
The numbers of shares of both types of stock are same as they were on January 01, 2016 because company has not issued any new shares of common or preferred stock during the year.
From the above data, we can compute the earnings per share (EPS) ratio as follows:
= ($1,500,000 – $180,000)/ 158,400
= $8.33 per share
The EPS ratio is $8.33. It means every share of the common stock earns 8.33 dollars of net income.
Significance and Interpretation:
The shares are normally purchased to earn dividend or sell them at a higher price in future. EPS figure is very important for actual and potential common stockholders because the payment of dividend and increase in the value of stock in future largely depends on the earnings of the company. EPS is the most widely quoted and relied figure by investors. In most of the countries, the public companies are required to report EPS figure on the income statement. It is usually reported below the net income figure.
There is no rule of thumb to interpret earnings per share. The higher the EPS figure, the better it is. A higher EPS is the sign of higher earnings, strong financial position and, therefore, a reliable company to invest money. For a meaningful analysis, the analyst should calculate the EPS figure for a number of years and also compare it with the EPS figure of other companies in the same industry. A consistent improvement in the EPS figure year after year is the indication of continuous improvement in the earning power of the company.