earnings per share is a company's net income per share of common stock it's calculated by
taking net income available to common shareholders which is net income minus dividends for preferred
shareholders and minus income attributable to non-controlling interest and dividing it
by the weighted average number of common shares outstanding we use net income available to common
shareholders in the numerator because companies only report earnings per share for common shares
and we use a weighted average for the number of common shares in the denominator because
new stock issuances and stock repurchases can cause the number of shares to fluctuate during
the period now earnings per share is the most widely used measure of profit it's the only ratio
that publicly traded companies are required to report on the income statement both u.s gaap and
ifrs require this and earnings per share is the accounting metric you'll hear most about in the
financial news particularly during earnings season publicly traded firms release their earnings four
times a year at the end of each quarter and analysts try to predict what their earnings per
share will be if those forecasts are compiled into what's called a consensus estimate the company
then releases its quarterly results which includes its earnings per share figure and then the
executives of the company go on a conference call and explain why the company did or did not reach
its forecasted earnings target if earnings per share happened to be higher than what analysts
had expected this is called an earnings beat if earnings per share happens to be lower than
what the analysts had expected this is called an earnings miss stocks often go up when there's an
earnings beat and they often go down when there's an earnings miss so why do people care so much
about earnings per share the answer has to do with valuation many investors value companies based on
their expected future cash flows so analysts spend a lot of time trying to figure out what
those future cash flows will be and what's the best predictor of future cash flows surprisingly
it is not current cash flows its earnings per share that's right a company's current earnings
per share is a better predictor of its future cash flows than the company's current cash flows this
explains why stock performance is more correlated with earnings per share than it is with operating
cash flow but that's not all when you divide a company's stock price by its earnings per share
you get something called the price to earnings ratio or p/e ratio for short the p/e ratio is
also known as an earnings multiple and it's a quick way to assess the relative value of a stock
companies with high p/e ratios are considered to be expensive whereas companies with low p/e ratios
are considered to be bargains you can benchmark a company's p/e ratio against the industry average
against the average for the market in general or against the p/e ratio for a competing firm
for example if you have two similar companies in the same industry the one with the lower p/e ratio
will generally be seen as a better value this is an important principle in value investing
where investors seek out companies with a low p/e ratio the main downside of the p/e ratio
is that it doesn't account for growth company a might have a higher p/e ratio than company b
because investors expect company a's earnings to grow faster to address this some investors use
the price-to-earnings to growth ratio or peg ratio for short the peg ratio divides the company's p/e
ratio by its growth rate for earnings per share so we've seen that earnings per share is incredibly
useful both in predicting future cash flows and in calculating the p/e ratio but when it comes
to being a measure of performance earnings per share isn't perfect for one thing earnings per
share does not account for the amount of assets or capital that had to be employed to achieve those
earnings for example let's say that two companies each had five dollars of earnings per share
it seems like they did equally well but what if one company had 500 million dollars of assets
whereas the other company had assets of just 10 million both companies achieved five
dollars of earnings per share but the second company did so using a lot fewer resources
this is where a metric like return on assets (roa) can be really helpful but there's
another issue with using earnings per share as a way to measure a company's performance
it can be increased simply by repurchasing shares let's say a company's profits are flat
and there's no growth if the company repurchases some common shares earnings per share will go up
even though there's been no improvement in the company's performance in fact it's even possible
for net income to go down yet earnings per share to go up if the company repurchases enough shares