What is EPS and how to interpret it?

EPS stands for Earnings Per Share. It indicates the proportion of net profits which belongs to each outstanding common stock. Simply put, it tells us how much profit a company has generated for each share of its stock.

Formula:

EPS = Net Income / Average Outstanding Common Shares 

Net profit is what is left with the owners of the company (equity shareholders) after all other providers of capital, i.e. debt and preferred shares, are paid.

Generally, an average of the opening and closing year balance is used to calculate the number of outstanding shares. This is because a company may issue or retire stocks during the course of the year, which may cause the number of shares to fluctuate. 

How to interpret EPS

EPS is a widely used metric for estimating a company's financial position. It is a key variable in establishing the value of a stock. Most investors will check the EPS of a company to understand its profit-generating ability before making an investment.

They look at trends in EPS year-over-year or quarter-over-quarter to analyse whether the company is getting better at generating profits or worse. For example, if the company had a higher EPS this year compared to five years ago, it could mean it has become more efficient financially.

Hence, a company with a steady rise in its EPS is considered a reliable investment compared to the one that shows a declining trend.

Quarter-over-quarter trends can help investors understand seasonality in the company's earnings. For example, an ice cream maker will probably have better earnings during the summer months than in winter. Hence, its stock may perform well going into summer while show sluggishness entering winter.

A company with a high EPS also has a greater ability to reward its shareholders in the form of dividends. Alternatively, it can use the profits to fund future growth.

Traders also use EPS to compare the value of the company with its competition or the industry it operates in. If two companies operate in the same industry, are similar in size and have the same cost drivers, the investor will choose the company which has a higher EPS.

EPS is also used to calculate other key financial ratios such as the Price Earnings (P/E) valuation ratio.