# Are Taxes Deducted Before Calculating EPS?

By: Kevin O'Flynn

A company's earnings per share is calculated in a two-step process. First, investors subtract all expenses, including taxes, from a company's sales. The result, net income, is then divided by the average number of shares outstanding. Investors should also calculate the diluted earnings per share to check the potential impact that convertible securities might have on EPS.

## Tax Included Among Expenses

Taxes are included in the earnings per share calculation. Investors can scan through a company's annual report to calculate EPS. Subtract all expenses from sales, including taxes, then divide the resulting net income by the weighted average number of shares outstanding. For example, if a company earned \$100 million of net income in 2011 and had a weighted average of 50 million shares outstanding, the EPS would equal \$2 per share.

## Personal Investment Return

Investors can utilize EPS to understand how a stock's net income affects the portion of a company owned by the individual. An individual investor can calculate a return on a stock by dividing the EPS by the average price the shareholder paid for the security. For example, if a company's EPS for the period was \$2 and the average price paid per share by the investor was \$30, then the return would be 7 percent.

## Share Price Connection

EPS is a useful investment tool to judge whether a share price is expected to rise. The price-to-earnings ratio, P/E, is calculated by dividing the company's current price by EPS. For example, if a company trades for \$33 a share and the latest EPS is \$2.90, then the P/E ratio is 11.38. If the company's forecast EPS is higher than \$2.90 and the P/E ratio remains constant, then the share price is expected to grow.

## Warning: Diluted Earnings

Diluted earnings per share is an important factor for investors to consider. DEPS measures the effect of convertible securities on the EPS ratio. Often companies award stock options and sell convertible bonds and convertible preferred stock. If these items are converted to common stock, then the weighted average number of shares for the company will increase. Having a larger denominator and the same size numerator in the EPS equation will lower the per share performance and possibly drive down the stock price.