Testing Earnings per Share (EPS) Against Change in Bottom Line
Managers should keep in mind that company shareholders expect to profit from stock ownership. The more earnings per share (EPS) your company can generate, the more likely investors are to receive dividends. Also, a growing EPS number may lead new investors to buy your company’s stock.
The increase in the stock’s price allows existing shareholders to sell their stock for a gain. Earnings per share is a key number to attract and keep investors.
Going over EPS
Companies report net income along with their income statements. Below this total profit number for the period, public companies also report earnings per share (EPS), which is defined as net income divided by shares of common stock outstanding.
Private companies don’t always report EPS; however, the EPS for a private business is fairly easy to calculate — divide its net income by the number of shares held by the equity investors in the company.
The market value of stock shares of a public company depends mainly on its EPS. Individual investors obviously focus on EPS, which they know is the primary driver of the market value of their investment in the business. The book value per share of a private company is the closest proxy you have for the market value of its ownership shares.
Mulling over changes in EPS
Generally, the higher the EPS, the higher the market value for a public company. And, the higher the EPS, the higher the book value per share for a private company. Now, you’d naturally think that if net income increases, say, 10 percent over last year, then EPS would increase 10 percent.
Not so fast. EPS — one driver of market value and book value per share — may change less than 10 percent, or perhaps more than 10 percent.
When considering changes in earnings per share, keep the EPS formula in mind:
Earnings per share = Net income / Stock shares outstanding
Note that the numerator is net income and that shares of stock are in the denominator.
Suppose, for example, that net income increases 10 percent over last year. EPS may not increase the full 10 percent. The business may have issued additional stock shares during the year, or it may have issued additional management stock options that get counted in the number of shares used to calculate diluted EPS. Both situations increase the denominator of EPS. If net income stays the same, EPS declines.
In doing this analysis, you may find just the reverse. EPS may increase more than the 10 percent increase in net income. The business may have bought back some of its own shares, which decreases the number of shares used in calculating EPS. If net income is unchanged, EPS rises. This could be a deliberate strategy for increasing EPS by a higher percentage than the percent increase in net income.
EPS doesn’t necessarily move in sync with the net income of a business. A change in earnings per share can change the market price of the firm’s stock.