EPS is the abbreviated form of Earnings per Share. Of course, there are other terms clipped as EPS: Extended Portfolio System is one, for example.
Those are not our concern here. In issues concerning the stock market, the direct concern is earnings from stocks. We take up EPS as Earning per Share and try to understand what it is.
In this sense, EPS is clearly a measure of average earning from shares transacted.
Here’s a simple formula for calculating EPS: divide the earnings available to common shareholders with the weighted average number of common shares outstanding during the year. The resulting quotient is called basic (or simple) EPS.
Often EPS is taken to be the single most important factor in the financial statement. Conventionally it is known as the “bottom line” indicator of financial performance.
Other commonly used ratios such as P/E and dividend payout are also calculated on the basis of EPS numbers.
Basic EPS is shown in the income statement of a company when it has no outstanding securities convertible into common stock.
When outstanding convertible securities are there, more complex rules are followed, which try to make EPS reflect the potential of such securities to dilute the potential earnings of common shareholders.
The kind of importance popularly attached to EPS by users of financial statements is perhaps due to the fact that they are disclosed in the financial statements of public companies, and are liable to be scrutinized by auditors.
But then EPS is tedious and cumbersome to creators and scrutinizers of financial statements. Complex provisions of APB 15 and a host of amending pronouncements make it further complicated.
The burden is worsened by SEC stipulation that 10-K reports include a supplementary schedule explaining the computation of EPS whenever it is not apparent in the financial statements.
A serious problem with ongoing standards is that basic EPS is subject to replacement on the income statement by two hypothetical EPS numbers: primary EPS, and fully diluted EPS.
Primary EPS is computed assuming that common stock equivalents were converted to common stock on the first day of the reporting period. The fully diluted EPS is computed assuming that all dilative securities, including the common stock equivalents, were converted.
When fully diluted EPS is less than 97% of basic EPS, these two EPS are the only per-share disclosures required under current accounting standards.
Concerns about the usefulness of dual EPS reporting are not limited to the relative merits of historical and proforma disclosure.
Some of the specific rules governing the computation of primary and fully diluted EPS have also been questioned. The test used to identify common stock equivalent securities is among the most controversial of those rules.
Changing prevailing market conditions in relation to terms of particular securities are not considered in the computational rules for EPS.
It implies that the appeal of a conversion feature relative to other security characteristics will vary, in different circumstances.
But then the meaning of common stock equivalent status and primary EPS remain confusing and questionable. There are other sophisticated methods that are also questionable, such as Options, Warrants, and the Treasury Stock Method.
So EPS is a popular method of measuring how things are going in the stock market, but the dependability of the measure is not too high because of the complicated procedures and unrealistic assumptions used for its derivation.
There are more comprehensive statistics and formulae that make life in the stock market simpler: the track of the P/E ratio for example.
Hence though as a primary indicator of performance one can use EPS to get an initial impression, you shouldn’t depend much on it for a deep understanding of what’s happening in the stock market.
