Tag: Price earning ratio

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 each2,000,000
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 * 6/12200000
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 outstanding5,50,000

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?

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 companiesPE Ratio
High growth companies Typically have a high PE ratio because investors expect future earnings to increase significantly.
High risk companiesOften have a low PE ratio because of the uncertainties or risks associated with their business.
Firms with high reinvestment needsMight 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.