Earnings per share represents that portion of company income that is available to the holders of its common stock. The measure is closely monitored by investors, who use it to estimate the performance of a business.
The formula for earnings per share is a company's net income minus any dividends on preferred shares, divided by the number of common shares outstanding. The number of shares outstanding is commonly expressed as the weighted average number of shares outstanding over the reporting period. The formula is:
(Net income - Preferred stock dividends) ÷ Number of common shares outstanding
For example, a business reports $100,000 of net income. The entity also issued $20,000 as a dividend to the holders of its preferred stock. The weighted average number of common shares outstanding during the period was 1,000,000. The calculation of its earnings per share is as follows:
($100,000 Net income - $20,000 Preferred dividends) ÷ 1,000,000 Common shares outstanding
= $0.08 earnings per share
Diluted earnings per share expands on the basic earnings per share concept by also including the effects of the conversion of convertible instruments and outstanding stock warrants (which reduces the amount of earnings per share). If a business has issued a large number of these convertible instruments, the amount of diluted earnings per share could be substantially less than the basic earnings per share figure.
The earnings per share concept can be expanded upon to also calculate the percentage change in earnings per share over time, which gives investors a better view of how they are trending. The measure is also useful for comparing the results of businesses that are of different sizes, since their results are reduced down to a common measure.
The earnings per share concept is of some value to the investor, but it ignores several other factors, such as:
- The efficiency with which a business uses capital to fund its operations
- The outlook for future sales of its products
- Trends in its expenses over time
- The value of the intangible assets generated by a business, such as its branding efforts
Consequently, the investor should consider earnings per share to be just one of several factors to consider when evaluating a business.