Earnings per share is a measure of how much profit a company has generated. Companies usually report their earnings per share on a quarterly or yearly basis.
Calculating earnings per share
Earnings per share is the portion of a company's profit that is allocated to each outstanding share of its common stock. It is calculated by taking the difference between a company's net income and dividends paid for preferred stock and then dividing that figure by the average number of shares outstanding.
Let's say a company has a net income of $20 million and pays out $2 million in dividends to preferred stockholders. Let's also say that company has 10 million shares outstanding for the first half of the quarter and 12 million shares outstanding for the second half, or an average of 11 million shares. In this case, here's how we would calculate earnings per share:
$20 million - $2 million = $18 million
$18 million / 11 million shares = $1.63/share
Thus this company's earnings came to $1.63 per share.
Diluted earnings per share
While the basic earnings-per-share formula only takes a company's outstanding common shares into account, the diluted earnings-per-share calculation takes all convertible securities into consideration. A company might have convertible preferred shares or stock options that could theoretically become common stock. If this were to happen, the result would be a reduction in earnings per share, and as such, a company's diluted earnings per share will always be lower than its basic earnings per share.
Using our example, let's say the company above has issued 2 million convertible preferred shares. In this case, the new earnings per share would be $1.38 ($18 million divided by 13 million).
Significance of earnings per share
Earnings can cause stock prices to rise, and when they do, investors make money. If a company has high earnings per share, it means it has more money available to either reinvest in the business or distribute to stockholders in the form of dividend payments. In either scenario, the investors win.
Limitations of earnings per share
When a company's earnings increase, it's an indication that the company is doing well financially and that it's potentially a worthwhile investment. But as a measure of a company's financial health, the earnings-per-share calculation has its limitations. Because companies have the option to buy back their own shares, they can improve their earnings per share by reducing their number of shares outstanding without actually increasing their net income. In this regard, companies can essentially manipulate investors into thinking they're doing better than they actually are. Furthermore, earnings per share does not take factors such as a company's outstanding debt into account.
Finally, earnings per share does not consider the capital needed to generate the earnings in question. If two companies report the same earnings per share but one uses less capital to bring in that income, that company is probably managing its resources better than its counterpart. However, that fact wouldn't be reflected in its earnings per share.
Put this information to good use and get started investing today! We have a number of offers from online brokers.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!