What is Basic EPS?
Basic Earnings Per Share (EPS) is a measure of profitability representing the amount of net profit allocatable to each share of common stock outstanding.
Since basic EPS is denoted on a per-share basis, companies of different sizes can be compared against one another – albeit there are shortcomings that you must be aware of regarding the use of this metric.
How to Calculate Basic EPS (Step-by-Step)
The basic EPS is calculated by dividing a company’s net income by the weighted average of common shares outstanding.
Equity holders have the potential to obtain greater returns relative to debt and other forms of capital, because they must receive more compensation for taking on this increased risk – or said differently, higher risks should equate to higher potential returns.
However, if the company has preferred dividends, we must subtract the value of the dividends paid out to preferred shareholders, because preferred dividends are treated “debt-like.”
- Preferred Shareholders: Preferred shareholders, as implied by the name, take precedence over common shareholders. Any payments made to them, similar to interest payments to lenders, must be deducted from the residual profit remaining for common shareholders.
- Common Shareholders: While common shareholders have the greatest upside potential, in return, this group of capital providers is placed at the very bottom of the capital structure (i.e. lowest priority).
Basic EPS Formula
To reiterate, the formula for calculating basic EPS involves dividing net income by the number of common shares outstanding.
What is a Good Basic EPS? (High or Low)
As a general rule, higher basic EPS values signal greater firm value as in these cases, the market will tend to be willing to pay a premium for each share of a company’s equity.
Let’s say that a company has consistently produced higher EPS figures compared to comparable companies in the same (or adjacent) sector.
Assuming that enough side diligence was conducted, the vast majority of rational investors are willing to pay a higher price for companies with a solid track record of consistent profitability.
A high EPS, in favorable instances, can stem from any of the following causes:
- Sustainable Competitive Advantage (i.e. “Economic Moat”)
- Market Leadership (i.e. High Market Share, Pricing Power)
- Strong, Competent Management Team
- Loyal, Recurring Customer Base – Potentially Significant % of Contractual Revenue
All else being equal, the market tends to be willing to pay more for companies with higher net profits.
One caveat, however, is that high-growth companies with minimal profits at the “bottom line” can still obtain high valuations from the market.
The reasoning is that the market is forward-looking, and therefore paying for the *potential* improved profitability in the coming years once the company matures (i.e. projected EPS).
While the company may be struggling to remain profitable or may even be unprofitable, investors can attach high valuations for such companies on the notion that the company will become profitable someday – but for the time being, “top-line” revenue growth is often the single-minded objective shared between the early-stage company and its investor base.
But in the case of mature industries in which low EPS figures are considered the norm, any companies with negative profitability are unlikely to receive favorable valuations.
For companies in the later stages of their maturity cycle, lower profit margins tend to coincide with reduced free cash flows (FCFs) as well as fewer growth opportunities, which collectively result in lower valuations.
Limitations of Basic EPS
Note that in the calculation of basic EPS, the share count used accounts only for the number of straightforward common shares.
As such, basic EPS neglects the potentially dilutive impact associated with the issuance of dilutive securities (i.e. options, warrants).
For instance, if you own a company and decide to compensate employees with stock-based compensation via options and warrants, those contracts increase the share count once executed or the vesting period has passed.
Common examples of potentially dilutive securities to be weary of are the following:
- Restricted Stock Units (RSUs)
- Convertible Debt Securities
- Preferred Stock with Conversion Feature
If these securities are “in-the-money”, which means that these financial contracts are profitable to execute (i.e. with a monetary incentive), the total share count should factor in the net impact of these securities.
Otherwise, there is the risk that the EPS figure will be inflated by ignoring the potentially dilutive impacts of such issued securities, which can cause the metric to be misleading (and possibly overstated).
Another consideration is that in practice, it has gradually become the norm to account for securities even if they are “out-of-the-money” based on the premise that they’ll turn profitable (and be dilutive to existing equity holders) someday – just on a later date.