While the math may be simple … there are many varieties of Earnings per Share (EPS) being used these days, and investors must understand what each represents so they can make informed investment decisions.
For example, the EPS announced by a company may differ significantly from what is reported in its financial statements and could also be different from what appears in the headlines!
As a result, a stock may appear over or under valued depending on the EPS being used.
By definition, EPS is net income divided by the number of shares outstanding. However, both the numerator and denominator can change depending on how you define “earnings” and “shares outstanding.”
Shares outstanding can be classified as primary (“primary EPS”) and fully diluted (“diluted EPS”). Primary EPS is calculated using the number of shares that have been issued and held by investors. These are the shares that are currently in the market and can be traded.
Diluted EPS entails a complex calculation that determines how many shares would be outstanding assuming all exercisable warrants, options, etc. were converted into shares at a point in time, generally the end of a quarter.
We prefer diluted EPS because it is a more conservative number that calculates EPS as if all possible shares were issued and outstanding.
Companies report both primary and diluted EPS, and the focus is generally on diluted EPS, but investors should not assume this is always the case.
Sometimes, diluted and primary EPS are the same because the company does not have any warrants or convertible bonds outstanding.
As has been evident in recent headlines, EPS can be whatever the company wants it to be, depending on assumptions and accounting policies!
Corporate “spin-doctors” focus media attention on the number the company wants in the news, which may or may not be the EPS reported in documents filed with the authorities.
Based on a set of assumptions, a company can report a high EPS, which reduces the P/E multiple and makes the stock look undervalued.
This is why it is critical for investors to read carefully and know how the EPS is calculated.
Caveat Investor! (Investor Beware) …
There are many types of EPS being used and investors need to know what the “EPS” represents and determine if it is a valid representation of the company’s earnings.
A stock may look like a great value because it has a low P/E …
But that ratio may be based on assumptions you may not agree with!