Calculating Earnings per Share

The basic formula for EPS is net operating profit divided by the number of shares outstanding. It is calculated after tax, and after dividends have been issued:

Although the formula appears straightforward, its components may bring in complications.

For example, "shares outstanding" may be classified as "primary" or "fully diluted." Primary means shares that are available to be bought and sold on the market. Diluted EPS takes the number of shares that would be available if all warrants, options and bonds were converted at a certain point in time (usually the end of a quarter). An example might be when a company issues share options to its employees. If a large number are exercised in the near future, it could make a considerable difference to the total shares available to be traded, and thus affect the value of EPS. In such circumstances, companies may report both primary and diluted EPS. Companies may also report "extraordinary EPS," which does not include the effect of atypical events, like the termination of a particular part of the business.

The definition of earnings can also differ, resulting in varying EPS. For example, "reported earnings" defines income according to "generally accepted accounting procedures" (GAAP), while "pro forma earnings" may exclude certain atypical expenses or revenue. Supporters of the latter argue that EPS is less likely to be distorted, enabling comparisons to be made on a more equivalent basis. However, when atypical expenses are cropping up regularly, it could suggest that earnings figures are being manipulated to achieve a particular end, rather than to report EPS as accurately as possible.

Another alternative is "cash EPS," which defines earnings as operating cash flow divided by diluted shares outstanding. This method is regarded as more dependable, because is uses actual cash income that takes account of changes in inventory and receivables, for example.

It's important that investors understand what's behind each type of EPS before they select stocks. A pro forma EPS, for example, could be quite different from the version that appears in a company's financial reports. These differences can also make a difference to the value placed on stock by the market.

It's also important to check whether any shares have been issued recently, as this could have quite an impact on EPS. If shares have been issued during the period being analyzed, check that the accepted practice of using a weighted average has been adhered to (rather than the opening or closing figure).

The standard method used to calculate price-to-earnings ratios is "trailing" EPS—which adds together the last four quarterly results for EPS.

If a company has no warrants, options or bonds outstanding, then primary and diluted EPS could be the same. But it's wise to make no assumptions and find out exactly what is meant by "shares outstanding."