Finance – Page 3 – Learn-Do Finance

What is Earnings per share (EPS)?

Earnings per share (EPS) is the company’s net profit available to equity shareholders (common stockholders) divided by the number of outstanding common shares.

EPS is reported on the face of the income statement / profit & loss statement.

How EPS is calculated?

Earnings per share (EPS) (also known as Basic EPS) is calculated as under:

Basic EPS = (Net income – Preferred dividends) / Weighted average number of shares outstanding

The weighted average number of shares outstanding is calculated by the length of time each quantity of shares was outstanding during the year.

Example: A company has reported following numbers on 31.12.20X1:

Particulars	$
Net income (PAT)	1,300,000
Preference shares 10%, 2,000,000 shares of $1 each	2,000,000
Common stock outstanding on 01.01.20X1 400,000 of $1 each
Common stock issued on 01.07.20X1 400,000
Common stock repurchased on 01.10.20X1 200,000
Common stock outstanding on 31.12.20X1 600,000

EPS llustration

Step 1: Calculation of weighted average number of shares outstanding:

400,000 shares * 6/12	200000
8,00,000 shares * 3/12 i.e. (400,000+400,000)	2,00,000
6,00,000 shares * 3/12 i.e. (800,000-200,000)	1,50,000
weighted average number of shares outstanding	5,50,000

Step 2: Net profit available to equity shareholders = PAT – Preference shares dividend

= 1,300,000 – 200,000* = 1,100,000

Step 3: Basic EPS = 1,100,000 / 550,000 = $ 2

*10% of $ 2,000,000 Preference shares capital

Utility of EPS

A comparison of year on year EPS growth indicates that profit per share is increasing which is positive for investor and vice versa.
From investor perspective, EPS indicates how much profit is earned on each share.
EPS is used an input into the price/earnings ratio.

Related articles:

Diluted EPS

What is PE Ratio?

How Compound interest works to grow wealth?

My wealth has come from a combination of living in America, some lucky genes, and compound interest“
– Warren Buffett

Compound interest means interest on interest. It is the result of reinvesting interest, rather than taking it out.

To understand the concept, let us assume $10,000 is invested @ 5% interest which is withdrawn at the end of each year. Total simple interest earned will be $ 1500 at the end of 3 years

Year	Principal	Interest @ 5% p.a.
1	10,000	500
2	10,000	500
3	10,000	500
	Total interest	1500

Table 1: Simple interest

Let us assume $10,000 is invested @ 5% interest which is reinvested at the end of each year. This means at the end of year 1, interest earned $ 500 will be added to $ 10,000 principal and interest will be calculated for year 2 on $ 10,500 amounting to $ 525. Total cumulative interest earned will be $ 1576 at the end of 3 years

Year	Principal	Interest @ 5% p.a.
1	10,000	500
2	10,500 (10000+500)	525
3	11025 (10500+525)	551
	Total interest	1576

Table 2: Compound interest

We can see that compound interest results in interest of $1576 at the end of 3 years compared to simple interest of $ 1500, i.e. an extra interest of $ 76 by just keeping interest reinvested.

One can see, how power of compounding can help grow your wealth much faster.

What is PE Ratio?

What is PE ratio?

The Price-to-Earnings (PE) Ratio is a valuation metric used to determine the relative value of a company’s shares by comparing its share price to its earnings per share (EPS). It essentially reflects how much investors are willing to pay for each dollar of a company’s earnings.

PE ratio shows how many years it will take to recover the money invested in a company assuming it’s earnings remain constant.

Calculation of PE ratio

The formula for PE ratio is as under:

PE ratio = Price / Earning per Share (EPS)

For example, XYZ ltd. EPS is $ 5 and market price of the share is $ 50. The PE ratio in this case will be 10.

This means that investors are willing to pay 10 times the company’s earnings for each share. In other words, it would take 10 years of the company’s earnings to recover the investment in its shares, assuming constant earnings.

PE Ratio Interpretation

High PE Ratio: Often indicates high growth expectations, meaning the company might be perceived as having strong future prospects. However, it could also indicate that the stock is overvalued.
Low PE Ratio: Could indicate lower growth expectations or a riskier business model, which may cause investors to discount its value. Conversely, it might signal an undervalued stock.

Type of companies	PE Ratio
High growth companies	Typically have a high PE ratio because investors expect future earnings to increase significantly.
High risk companies	Often have a low PE ratio because of the uncertainties or risks associated with their business.
Firms with high reinvestment needs	Might also have lower PE ratios as a lot of their profits are reinvested back into the business rather than being reflected in current earnings.

Limitations

The PE ratio can be influenced by a company’s capital structure (debt vs. equity), which might distort its valuation.

It may not always provide a complete picture, especially when comparing companies with different levels of debt or capital investment needs.

For a more comprehensive assessment, other multiples like EV/EBITDA (Enterprise Value to Earnings Before Interest, Taxes, Depreciation, and Amortization) are often used, as they neutralize the effects of capital structure differences.

The PE ratio, while useful, should be considered alongside other financial metrics to get a full understanding of a company’s value.

Rule of 72

The rule of 72 is used as rule of thumb for estimating an investment’s doubling time.

The formula of Rule of 72 is

T = 72/r

Where

r = rate of interest / year

T = number of periods required to double an investment’s value

For example, we want to know what is the time required to double investment @ 6% rate of interest.

It will take 12 years ( T = 72 / 6) to double the interest.

So, next time someone asks you to tell how much time an investment at a certain rate of interest takes to double your money, use of Rule of 72 can be a quick handy tool and you do not need our calculator or laptop.

It may be noted that Rule of 72 & other variations i.e. the rule of 70 and the rule of 69.3 gives approximate time an investment takes to double the investment.