Stock Price Evaluation: Earnings Per Share and Diluted Earnings Per Share

There are many ways for investors to evaluate company profitability and stock prices. In fact, it is suggested by many advisors and analysts that multiple financial measures be used to fully understand a company’s existing and potential performance that could lead to an increase in dividend payouts and returns from an increase in stock price. Two of these important measures are the earnings per share (EPS) and diluted earnings per share. Both are a ratio that reflect a corporation’s net income and allow investor’s a simplified way to compare the stock price and performance of different companies.

Earnings per share and diluted earnings per share are calculated ratios of a company’s net income to the number of common stock shares outstanding. As stated above, the EPS figures reflect a company’s profitability, so a higher EPS can indicate higher net income. When comparing two or more stocks, the EPS allows for a basic comparison of the companies’ earning potential. For example, if someone were reviewing two companies in the same industry and sees that Company A has an EPS of $5.00 and Company B has an EPS of $10.00, it would be clear that Company B is simply earning more money per share than Company A. This is not to say that Company B is actually more profitable, it could simply have less issued shares than Company A.

Diluted earnings per share is calculated the same way as basic EPS in relation to the number of shares outstanding, however, the math used for the amount of shares outstanding is taken a step further. Under diluted earnings per share, any issued long-term debt (bonds/stock options) or convertible preferred stocks must be accounted for in the amount of shares outstanding. This causes diluted earnings per share to be less than basic EPS in dollar amount, but not necessarily less important or a reflection that the company stock is over valued. Actually, some investors or analysts prefer to base investing decisions from the diluted EPS figure since it reflects an entity’s use of various stock options and shows a worse case scenario for pricing if all options were to be put into place.

Sometimes both basic EPS and diluted EPS will be taken a step further to evaluate an entity’s future performance. These predicted calculations will use expected future net income in order to show a possible increase or decrease in EPS. These figures are another matrix that investors can use to easily compare and contrast a company’s performance from today to a point in time in the future, usually one fiscal year. The hope is that investors can make easy value determinations of their stocks based on the expected future earnings by using simplified ratio matrices.

Some may argue that EPS is the most important figure available in evaluating a company and their stock price. At the end of the day, investors simply want to know how much money the companies they have invested in are earning, and the EPS figures put that in an up-front and easy to understand number. The EPS is used directly to calculate a stock’s price/earnings (P/E) ratio. While the P/E ratio is another very important evaluation number, it would require it’s own article for full explanation, the EPS is a factor in calculating the P/E ratio so therefore some analysts rank the EPS higher in importance. The P/E ratio tells an investor how much they are paying for $1.00 in company earnings by purchasing the stock. The use of EPS in this ratio ties them together in the evaluation of a company’s net income and determination of how expensive a share price truly is.

The basic earnings per share and diluted earnings per share figures are just two of multiple numbers, figures, and matrices used in determining the true value of a company, its share price, and potential return on one’s investment. As stated before, the EPS should not be the only factor used to finalize an investment decision, but it may be the most important. The EPS may be the most direct way to answer the question of how much a company makes and what that entity is worth.