Earnings per share, or EPS, is one of the most important metrics used in stock valuation. EPS tells you how much the company earned per common share and measures the firm's efficiency in managing the funds entrusted to it by shareholders. Since EPS is calculated for common stock, you must first figure out how much of the profits belong to common shareholders after other stockholders, who have priority in the financial structure, have been fully paid.
Common vs Preferred Stock
Corporations issue two types of shares -- common and preferred. Common stock allows the holder to receive a portion of the company's profits in perpetuity and also to vote to elect the board of directors in the annual shareholders meeting. Preferred shares, on the other hand, entitle the holder to a fixed annual payment. No matter how profitable the firm, the preferred stockholder cannot get more than this predetermined sum. These shares are "preferred" in the sense that the common shareholders cannot be paid until preferred stockholders have been paid in full. Should the firm go bankrupt, preferred shareholders are paid before common stockholders can receive a portion of the proceeds resulting from the dissolution. However, preferred stockholders cannot vote in the annual shareholders meeting.
Preferred shareholders do not really care about the firm's profitability, as long as the company is sufficiently healthy to pay them the fixed annual sum they are entitled to. Therefore, EPS is only calculated for common stock. Unlike preferred stockholders, common shareholders stand to gain more if the firm's profits are larger. To calculate the EPS for common shares, subtract the preferred dividends from the corporation's net income and then divide the result by the number of common stock outstanding. You cannot calculate the EPS unless you know the number of preferred shares and the annual dividend payable to each preferred share.
Imagine the company earned $2,500,000 over the last full financial year. This firm has 30,000 preferred shares outstanding and each share is entitled to receive $10 per year in preferred dividends. The company also has one million common shares. Total preferred dividends equal 30,000 times $10, or $300,000. Subtracting $300,000 from $2,500,000 equals $2,200,000. This represents the earnings available to common shareholders. Since there are one million common shares, the earnings per common share equals $2,200,000 divided by 1,000,000, or $1.10 per share. So, the firm earned $1.10 per share of common stock, after accounting for all other obligations that must be honored before common shareholders can be paid.
EPS vs. Dividends
The company's board of directors can decide to pay all or some of its earnings to common shareholders in the form of dividends or to invest some of it back in the business. In a growing company that needs to spend heavily to stay competitive, the board may even decide not to pay any dividends at all and pour the entire profits back into the business. Common shareholders who are unhappy with the firm's dividend policy can vote the board out in the next shareholder meeting, but that is their only recourse.
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