What is Basic EPS?
Basic Earnings Per Share (EPS) is a measure of profitability representing the amount of net profit allocatable to each share of common stock outstanding.
Since basic EPS is denoted on a per-share basis, companies of different sizes can be compared against one another – albeit there are shortcomings that you must be aware of regarding the use of this metric.
- What is the formula used to calculate basic earnings per share (EPS)?
- How do you interpret the basic EPS figure when it comes to comparisons among different companies?
- Explain the most concerning drawback to the basic EPS metric.
- How does change in net income and changes in the common share count impact basic EPS?
Table of Contents
How to Calculate Basic EPS
The basic earnings per share (EPS) metric refers to the total amount of net income that a company generates for each common share outstanding.
The basic EPS is calculated by dividing a company’s net income by the weighted average of common shares outstanding.
However, if the company has preferred dividends, we must subtract the value of the dividends paid out to preferred shareholders, because preferred dividends are treated “debt-like.”
Preferred shareholders, as implied by the name, take precedence over common shareholders. Any payments made to them, similar to interest payments to lenders, must be deducted from the residual profit remaining for common shareholders.
Equity holders have the potential to obtain greater returns relative to debt and other forms of capital, because they must receive more compensation for taking on this increased risk – or said differently, higher risks should equate to higher potential returns.
Basic EPS Formula
To reiterate, the formula for calculating basic EPS involves dividing net income by the number of common shares outstanding.
Basic Earnings Per Share (EPS) Formula
- Basic EPS = (Net Income – Preferred Dividends) / Weighted Average Common Shares Outstanding
Interpreting the Basic EPS – Higher or Lower Ratio?
As a general rule, higher basic EPS values signal greater firm value as in these cases, the market will tend to be willing to pay a premium for each share of a company’s equity.
Let’s say that a company has consistently produced higher EPS figures compared to comparable companies in the same (or adjacent) sector.
Assuming that enough side diligence was conducted, the vast majority of rational investors are willing to pay a higher price for companies with a solid track record of consistent profitability.
Potential Causes of High Basic EPS Figures
- Sustainable Competitive Advantage
- Market Leadership (i.e. High Market Share, Pricing Power)
- Strong, Competent Management Team
- Loyal, Recurring Customer Base – Potentially Significant % of Contractual Revenue
All else being equal, the market tends to be willing to pay more for companies with higher net profits.
One caveat, however, is that high-growth companies with minimal profits at the “bottom line” can still obtain high valuations from the market.
The reasoning is that the market is forward-looking, and therefore paying for the *potential* improved profitability in the coming years once the company matures (i.e. projected EPS).
While the company may be struggling to remain profitable or may even be unprofitable, investors can attach high valuations for such companies on the notion that the company will become profitable someday – but for the time being, “top-line” revenue growth is often the single-minded objective shared between the early-stage company and its investor base.
But in the case of mature industries in which low EPS figures are considered the norm, any companies with negative profitability are unlikely to receive favorable valuations.
For companies in the later stages of their maturity cycle, lower profit margins tend to coincide with reduced free cash flows (FCFs) as well as fewer growth opportunities, which collectively result in lower valuations.
Limitations of Basic EPS
Note that in the calculation of basic EPS, the share count used accounts only for the number of straightforward common shares.
As such, basic EPS neglects the potentially dilutive impact associated with the issuance of dilutive securities (i.e. options, warrants).
For instance, if you own a company and decide to compensate employees with stock-based compensation via options and warrants, those contracts increase the share count once executed or the vesting period has passed.
Examples of Potentially Dilutive Securities
- Convertible Debt Securities
- Preferred Stock with Conversion Feature
If these securities are “in-the-money”, which means that these financial contracts are profitable to execute (i.e. with a monetary incentive), the total share count should factor in the net impact of these securities.
Otherwise, there is the risk that the EPS figure will be inflated by ignoring the potentially dilutive impacts of such issued securities, which can cause the metric to be misleading (and possibly overstated).
Another consideration is that in practice, it has gradually become the norm to account for securities even if they are “out-of-the-money” based on the premise that they’ll turn profitable (and be dilutive to existing equity holders) someday – just on a later date.
Basic EPS Calculator – Excel Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Basic EPS Example Calculation
First, we’ll begin by briefly explaining the operating assumptions used to calculate basic EPS.
As of 2020, the company’s latest fiscal year has the following financial data:
- Net Income: $200mm
- Preferred Dividends: $5mm
With those two assumptions stated, we can calculate the “Net Earnings for Common Equity” – which is the portion of net income attributable to just common shareholders – by subtracting the preferred dividends from net income.
So in 2020, the net earnings for common equity holders comes out to $195mm.
- Net Earnings for Common Equity = $200mm Net Income – $5mm Preferred Dividends
- Net Earnings for Common Equity = $195mm
Next, for the subsequent section, we must calculate the weighted average common shares outstanding for each period.
Net Income and Share Count Timing Mismatch
If you were wondering why we’re taking the weighted average of common shares, note that we must use the average balance due to the timing mismatch between the numerator and denominator.
The income statement (i.e. the source of net income) captures a period of time across two specified periods, whereas the share count data is based on a specific ending date (i.e. the balance sheet or the beginning section of 10-K/10-Q). Thus, we use the weighted average common shares to account for this time difference.
In Excel, the steps to calculate the basic EPS for each year is:
- Link to Net Earnings in the Applicable Period
- Divide by the Average Between the Current Period and Prior Period Common Shares Outstanding
Just as an example, the formula for the basic EPS in 2020A is listed below:
- Basic EPS (2021) = $205mm Net Earnings to Common ÷ AVERAGE (95mm, 100mm Common Shares)
- Basic EPS (2021) = $2.10
As for the rest of the forecast, we’ll be using various assumptions to show various operating scenarios and the net impact on basic EPS.
To start working through the projection period, we’ll begin with the net income assumptions:
- 2021: Net Income Increased by $10mm YoY
- 2022: Net Income Increased by $25mm YoY
- 2023: Net Income Decreased by $50mm YoY
In terms of our assumptions for preferred dividends, we’ll keep the amount fixed at $5mm each year. But the impact on basic EPS should be rather intuitive – i.e. increased preferred dividends causes lower EPS (and vice versa).
Then, our assumptions for the common shares outstanding can be found here:
- 2021: Common Shares Decreased by 5mm YoY
- 2022: Common Shares Decreased by 10mm YoY
- 2023: Common Shares Increased by 20mm YoY
Provided with our simplistic assumptions, the pattern should be clear that in the years when net income increases, common shares decline (i.e. share repurchases), while the number of common shares increases when net income falls (i.e. mandatory capital raise).
Therefore, our baseline basic EPS figure following moderately positive performance is $2.10 in 2021.
In comparison, after another year of strong performance, basic EPS is $2.42 as a result of the growth of $25mm in net income and a reduction of 10mm shares.
But in contrast, during the year depicting underwhelming performance, basic EPS contracts to $1.80 following a year of poor performance in which net earnings fell $50mm with the common share count expanding by 20mm shares.
In closing, a screenshot of our completed output sheet has been posted below. The net impact that changes in net income and the number of common shares have on basic EPS can be observed from our modeling exercise.