Physical Address
304 North Cardinal St.
Dorchester Center, MA 02124
When investing in the stock market, investors analyse several financial ratios to understand a company’s financial performance and determine whether its shares may be overvalued or undervalued. Some commonly used metrics include Earnings Per Share (EPS), the Price-to-Earnings (P/E) ratio, Return on Equity (ROE), and Debt-to-Equity ratio.
Among these metrics, EPS is one of the most important indicators of a company’s profitability. It tells investors how much profit is attributable to each ordinary share of a company.
But what is EPS in the stock market? How is it calculated, and how can investors use it to compare different companies?
In this article, we will explain the meaning of EPS, its formula, a practical example using a shoe-manufacturing company, and how EPS is used with the P/E ratio to analyse stocks.
What Is EPS in the Stock Market?
EPS stands for Earnings Per Share. It represents the portion of a company’s profit attributable to each outstanding ordinary share during a particular financial period.
In simple words, EPS helps investors understand how much profit a company generates for each ordinary share.
A company with growing EPS may be improving its profitability. However, investors should also examine revenue growth, debt, cash flow, share dilution, and other financial factors before making an investment decision.
EPS does not mean that the company distributes that amount to shareholders as cash. A company may retain its earnings to expand its business, repay debt, or fund other activities. Dividends are separate distributions declared by the company.
What Is the EPS Formula?
The basic formula for calculating Earnings Per Share is:
EPS = (Net Profit − Preference Dividends) ÷ Weighted Average Number of Ordinary Shares Outstanding
Where:
- Net Profit: The company’s profit after expenses, interest, and taxes.
- Preference Dividends: Dividends attributable to preference shareholders, where applicable.
- Weighted Average Number of Ordinary Shares: The average number of ordinary shares outstanding during the financial period, adjusted for changes in the number of shares over time.
For example, if a company earns ₹50 lakh in net profit, pays ₹5 lakh in preference dividends, and has 4.5 lakh weighted-average ordinary shares outstanding, its EPS would be:
EPS = (₹50,00,000 − ₹5,00,000) ÷ 4,50,000
EPS = ₹10 per share
This means ₹10 of the period’s earnings is attributable to each ordinary share. It does not mean each shareholder receives ₹10 in cash.
How to Calculate EPS: A Shoe Manufacturing Company Example
Let’s understand EPS with a practical example.
Suppose a shoe-manufacturing company sells shoes worth ₹2 crore during a financial year. We will calculate its operating profit, profit before tax, net profit, and finally its EPS.
Step 1: Calculate Revenue and Operating Expenses
Assume the company has the following financial figures:
| Particulars | Amount |
|---|---|
| Total revenue | ₹2,00,00,000 |
| Cost of goods sold (COGS) | ₹40,00,000 |
| Marketing and sales expenses | ₹20,00,000 |
| Office and administrative expenses | ₹30,00,000 |
| Total operating expenses | ₹90,00,000 |
Revenue represents the total sales generated by the company during the period. COGS includes the direct costs associated with producing the goods sold.
Marketing, sales, and administrative expenses are then deducted to calculate operating profit.
Operating Profit = Revenue − Total Operating Expenses
Operating Profit = ₹2,00,00,000 − ₹90,00,000
Operating Profit = ₹1,10,00,000 (₹1.10 crore)
Step 2: Calculate Profit Before Tax (PBT)
Suppose the company has interest expenses of ₹36 lakh on its loans.
Profit Before Tax is calculated by deducting interest and other applicable non-operating expenses from operating profit. For this simplified example, assume there are no other non-operating items.
PBT = Operating Profit − Interest Expense
PBT = ₹1,10,00,000 − ₹36,00,000
PBT = ₹74,00,000 (₹74 lakh)
Step 3: Calculate Tax and Net Profit
Assume the company has an effective tax rate of 30% for this example.
Tax = ₹74,00,000 × 30%
Tax = ₹22,20,000
Net Profit = Profit Before Tax − Tax
Net Profit = ₹74,00,000 − ₹22,20,000
Net Profit = ₹51,80,000 (₹51.8 lakh)
This is the company’s profit after tax under our simplified assumptions.
Actual tax expenses depend on the company’s applicable tax rules, deductions, and other circumstances. The 30% rate here is only an illustrative assumption.
Step 4: Calculate Earnings Per Share (EPS)
Now suppose the company has the following share structure:
- Net profit after tax: ₹51,80,000
- Preference dividends: ₹1,80,000
- Weighted-average ordinary shares outstanding: 5,00,000
Using the EPS formula:
EPS = (Net Profit − Preference Dividends) ÷ Ordinary Shares
EPS = (₹51,80,000 − ₹1,80,000) ÷ 5,00,000
EPS = ₹50,00,000 ÷ 5,00,000
EPS = ₹10 per share
Therefore, the shoe-manufacturing company has an EPS of ₹10 for the financial period.
This means ₹10 of earnings is attributable to each ordinary share. Whether the company retains these earnings or distributes some of its profits as dividends depends on its financial position and dividend policy.
How Is EPS Related to the P/E Ratio?
EPS is commonly used with the Price-to-Earnings (P/E) ratio to evaluate a company’s share valuation.
The P/E ratio compares the market price of a share with its earnings per share.
P/E Ratio = Market Price Per Share ÷ Earnings Per Share (EPS)
Suppose the shoe-manufacturing company’s share trades at ₹150 and its EPS is ₹10.
P/E Ratio = ₹150 ÷ ₹10
P/E Ratio = 15
This means investors are paying ₹15 in market price for every ₹1 of the company’s annual earnings per share.
Investors can use the P/E ratio to compare a company with similar businesses, its sector, and its own historical valuation. However, a P/E ratio alone cannot determine whether a share is overvalued or undervalued.
What Are Trailing EPS, Current-Year EPS and Forward EPS?
Investors may come across different types of EPS figures while analysing stocks. It is important to understand which period each figure represents.
1. Trailing EPS
Trailing EPS is calculated using earnings from a past period, commonly the latest four reported quarters, known as trailing twelve months (TTM).
It is based on reported historical results, although adjustments and reporting differences can affect comparisons.
2. Current-Year EPS
Current-year EPS refers to EPS for the current financial year. Before the year is complete, the figure may be an estimate or a combination of reported results and forecasts, depending on the source.
Always check whether the number is actual, estimated, or a TTM figure.
3. Forward EPS
Forward EPS is an estimate of a company’s future earnings per share, typically for the next financial year or another specified future period.
Analysts may use expected revenue, costs, profit margins, and the expected number of shares to estimate future EPS.
Forward EPS can help investors assess expected growth, but forecasts may differ from actual results.
How to Compare Two Companies Using EPS and the P/E Ratio
Let’s compare two hypothetical companies operating in the same sector.
| Particulars | Company A | Company B |
|---|---|---|
| EPS | ₹10 | ₹15 |
| Market price per share | ₹150 | ₹300 |
| P/E ratio | 15 | 20 |
| Illustrative sector P/E | 18 | 18 |
Company A
P/E Ratio = ₹150 ÷ ₹10 = 15
Company B
P/E Ratio = ₹300 ÷ ₹15 = 20
In this example, Company A has a P/E ratio of 15, while Company B has a P/E ratio of 20. If the sector P/E is 18 and all the figures use comparable periods and methods, Company A trades at a lower P/E than the sector, while Company B trades at a higher P/E.
However, a lower P/E does not automatically make Company A cheaper in terms of intrinsic value. Company B might have stronger growth prospects, better profitability, lower debt, or a more sustainable business model. Alternatively, Company A’s lower valuation could reflect weaker growth or higher risks.
Investors should analyse both companies’ financial performance, future prospects, cash flows, debt, and business quality before reaching a conclusion.
How to Compare a Stock’s P/E Ratio With Nifty 50 and Sensex
Investors sometimes compare a company’s P/E ratio with the P/E ratio of a broad market index, such as the Nifty 50 or Sensex.
This comparison can help provide context about market valuations, but it has limitations.
- Company P/E: Reflects the market price relative to the company’s earnings.
- Nifty 50 P/E: Reflects the valuation of the Nifty 50 index using the index provider’s methodology.
- Sensex P/E: Reflects the valuation of the Sensex using the relevant index methodology.
For a meaningful comparison, check the same date and use clearly defined valuation measures. A company’s sector or industry peers may provide a more relevant benchmark than a broad market index.
A stock trading below the Nifty 50 or Sensex P/E is not necessarily undervalued. Its growth, risk, business model, and profitability may differ substantially from the index constituents.
Why Is EPS Important for Investors?
EPS is useful for several reasons:
- Understanding profitability: It indicates how much earnings are attributable to each ordinary share.
- Evaluating earnings growth: Comparing EPS across periods can help investors assess whether profitability per share is improving.
- Calculating the P/E ratio: EPS is a key input in this widely used valuation metric.
- Comparing similar companies: EPS can help with analysis when companies are compared using consistent accounting periods and share-count methods.
- Assessing dilution: An increase in the number of outstanding shares can affect EPS, even if total profit grows.
EPS is most useful when considered alongside other financial measures, rather than as a standalone signal to buy or sell a stock.
Limitations of EPS
Although EPS is an important financial metric, it has limitations:
- It does not show the share’s valuation by itself: A company with high EPS may still have an expensive share price.
- It does not measure cash flow: Accounting profit and cash generated by operations are not always the same.
- It can be affected by share-count changes: Buybacks and new share issuance can change EPS.
- It does not measure debt or risk: Investors should also examine the balance sheet and cash-flow statements.
- It may be affected by one-off items: Exceptional gains or losses can make reported earnings less representative of ongoing performance.
- It cannot guarantee future growth: Historical EPS does not ensure that a company will earn the same amount or grow in the future.
For a more complete analysis, consider EPS alongside P/E, ROE, debt-to-equity, operating cash flow, and revenue and profit growth.
Read also : What Is XIRR in Mutual Funds? Meaning, Formula, Calculation, and Example.
