Earnings per share ratio | EPS ratio
/What is the Earnings per Share Ratio?
The earnings per share ratio (EPS ratio) measures the amount of a company's net income that is theoretically available for payment to the holders of its common stock. A company with a high earnings per share ratio is capable of generating a significant dividend for investors, or it may plow the funds back into its business for more growth; in either case, a high ratio indicates a potentially worthwhile investment, depending on the market price of the stock. This measure is only used for publicly-held companies, since they are the only entities required to report earnings per share information.
How to Use the Earnings per Share Ratio
If an investor is primarily interested in a steady source of income, the EPS ratio is useful for estimating the amount of room that a company has for increasing its existing dividend amount. However, in many cases simply reviewing a company's history of making changes to its dividend is a better indicator of the actual size of future dividends. In some cases, a company may have a high ratio, but pays no dividend at all, since it prefers to plow the cash back into the business to fund additional growth.
It is very worthwhile to track a company's earnings per share ratio on a trend line. If the trend is positive, then the company is either generating an increasing amount of earnings or buying back its stock. Conversely, a declining trend can signal to investors that a company is in trouble, which can lead to a decline in the stock price.
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How to Calculate the Earnings per Share Ratio
To calculate the ratio, subtract any dividend payments due to the holders of preferred stock from net income after tax, and divide by the average number of common shares outstanding during the measurement period. This information is available on a company's income statement and balance sheet. The calculation is:
(Net income after tax - Preferred stock dividends) ÷
Average number of common shares outstanding
Example of the Earnings per Share Ratio
ABC Company has net income after tax of $1,000,000 and also must pay out $200,000 in preferred dividends. It has both bought back and sold its own stock during the measurement period; the weighted average number of common shares outstanding during the period was 400,000 shares. ABC's earnings per share ratio is:
($1,000,000 Net income - $200,000 Preferred stock dividends) ÷
400,000 Common shares
= $2.00 per share
Disadvantages of the Earnings per Share Ratio
There are some problems with the earnings per share ratio. The main one is that a business can report an increased ratio without generating any additional earnings. This is done by buying back shares from investors, which shrinks the number of shares outstanding, as stated in the denominator of the calculation. Depending on the number of shares repurchased, this can result in quite a splendid increase in earnings per share. Another issue is that a business might use a variety of accounting tricks to artificially boost the reported amount of earnings, thereby increasing the ratio without actually generating any additional profits.
Terms Similar to Earnings per Share Ratio
The earnings per share ratio is also known as the EPS ratio.