If you own shares of stock, the concept of Earnings Per Share is an important one. To understand the idea, one first should comprehend that it is based on the fact that publicly-traded companies (usually these are the large ones like IBM or Walmart) long ago devised a method of dividing themselves into shares of ownership. And offered these individual slices of the business for sale to anyone who wanted to buy them. From the company’s perspective, it’s a fundraiser to pay for expanding operations. To the purchaser, it’s an investment. That’s where the concept of Earnings Per Share comes in.

## The Concept of Earnings Per Share

While generally associated with the stock market, Earnings Per Share (EPS) can be calculated, according to Generally Accepted Accounting Principles (GAAP), **on any instrument that results in shares being issued**. Some examples would be stocks, stock options, bonds, payment arrangements on a share base, and a few others. Why would an investor have an interest in knowing what the EPS for a particular company is? The short answer is EPS is a measure of profitability and an excellent quick-screening tool when assessing investment potential.

Digging deeper into the concept, the term Earnings Per Share itself implies that it will present a number that reveals **how much profit, or earnings, a company generates over the course of a year on a per share basis**. The basic formula for determining EPS is simple. Subtract the preferred dividends amount from net income and divide the result by the weighted average of outstanding shares to arrive at the basic EPS. This is a number to key on when skimming a company’s annual report or your favorite daily paper’s stock quotes.

Let’s examine the significance of EPS more closely. **A company with a high EPS has a more favorable outlook on the stock market**, which usually results in a greater demand for shares and a rise in the underlying stock price. This means more value for those who own shares. The simple fact that a high EPS exists implies the company will have cash available to expand operations or pay dividends to shareholders. Either is a good thing for anyone owning a piece of the action. Keep in mind that EPS is a basic calculation and shouldn’t be the only evaluation tool to determine a company’s investment worthiness. There are pros and cons to the EPS calculation.

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## Advantages and Disadvantages of Earnings Per Share

As a reader, you should glean from the preceding discussion of how to calculate EPS, that this is simple arithmetic and can’t hope to convey all the complex factors at play. Which you should consider when studying a company’s financials. In other words, knowing the EPS is a good starting point, but there is much more you should look at, and there are drawbacks to this basic number.

### Advantages of Earnings Per Share

**1. Saves Time**

As we alluded to earlier, a company’s basic EPS is great to use as **a screening tool**. There are literally thousands of potential opportunities in the stock market alone with which to invest. To conduct a detailed study of each and every one’s full financials before deciding to buy a single share would take a lifetime. And, by the time you would finish, there would be new companies to study. Think of the number as a marker you can use to separate the “maybe” from the “definitely not.”

**2. Serves as a Metric **

While we cautioned earlier against using the EPS as a replacement for a myriad of underlying complex factors, one advantage to knowing this number is that it does offer a shorthand way to at least **get a general feel** for everything that goes into determining ultimate profitability or lack thereof. It allows a potential investor to say, for example, with some confidence: “I don’t want to invest in any company with an EPS below $1.50 per share.”

**3. Provides Historical Perspective**

Investors new to the game should realize that there is danger in relying completely on EPS to compare one company’s profit potential against another’s, but it is a **fairly reliable indicator to look at over the long haul**. For example, check a company’s EPS numbers going back several decades. If it has consistently yielded a positive number, that should probably mean something when compared to a company with a mixed or negative historical EPS.

The bottom line is that the **EPS is a good thing to know**, but there are solid reasons not to bet the farm on it without understanding its limitations.

### Disadvantages of Earnings Per Share

**1. Triple Confusion**

There are actually **three different types of EPS**, each requiring a different formula: **basic EPS**, **diluted EPS**, **adjusted EPS**. We’ve already discussed the first. Diluted EPS is always lower than basic because it takes into account all outstanding assets that one can convert into shares, like stock options. The diluted EPS is a reflection of profit in a “worst case scenario” in which all possible convertible securities were, in fact, converted.

**2. Not a Reflection of Reality**

The adjusted **EPS strips out profits or losses resulting from non-core activities**. Remember this is** NOT the GAAP sanctioned figure**. The point here is that there are three different EPS numbers floating around. And you must be careful to know which formula is used to find the one you’re looking at. It makes a difference.

**3. Easy to Manipulate**

There are many ways an **EPS number can be distorted**. A company might conduct a buy-back program in which it repurchases its own shares. Thus reducing the overall number available in the marketplace and increasing the EPS. An investor should also be on the lookout if a company changes its accounting policy. GAAP allows for significant latitude in this and certain changes can move the EPS positively or negatively.

**4. Poor Comparison Tool**

The EPS does not take into account how much capital a company used to achieve that number. For example, two companies might have an identical EPS but company A needed twice as much capital to generate it as did company B. It’s obvious the latter was more efficient with its money and might be a tighter, better run company.

## The Bottom Line

We said all that to say this. The EPS is a tried and true indicator of financial health that has been used throughout the life cycle of modern global stock markets. It serves as an excellent metric to begin screening your stock investments. But you shouldn’t use it as your sole indicator. As we’ve discussed, there are inherent inaccuracies and omissions in the formula. How much, if at all, do you use the EPS in your investing life?

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