If you are new to investing you may be unfamiliar with all of the different types of earnings per share. It is very important that you know all of the different types so that you can use the correct one. Using the wrong earnings per share may give you an undesirable result. I have never met anyone who wanted to invest in a failing business so be sure that you know the difference.
It is important to note that earnings per share is defined as net income divided by shares outstanding. When you are looking for this data you always want to look at the documents that the company has filed with the Securities and Exchange Commission. The 10-Q or the 10-k are some of the documents that you want to focus on for this information.
Basic Earnings Per Share
So the first type that we will look at is primary earnings per share. For this type we know we will look at the reported net income and we will divide that into the shares outstanding. These are the shares which have already been issued by the company. So now let’s look at an example where ABC company reported $400,000 in net income and they have 1,000,000 shares outstanding.
(net income / common shares outstanding)
$400,000 / 1,000,000 = $0.40 primary earnings per share
This is a straightforward way to look at earnings per share. It is one of the most common ways to look at earnings per share but there are still other factors that can affect the earnings per share. Fortunately, there are other formulas that will help us look at those factors.
Diluted Earnings Per Share
A diluted earnings per share formula looks very similar to the basic one. The main difference is that the shares outstanding also included possible shares to be issued by the company. These possible shares could come from several sources like stock options, warrants or convertible bonds. Building on the first example, let’s say that ABC company also has 200,000 diluted shares. The formula would now look like this.
(net income / common shares + employee stock options + convertible preferred shares + convertible bonds + warrants)
$400,000 / 1,200,000 = $0.33 diluted earnings per share
Here we can see that just making this one simple change to our formula that we were able to get a very different result. The number of diluted shares can greatly affect the results of this equation. The more diluted shares the smaller the earnings per share will be.
Reported Earnings Per Share
Both types that we have discussed so far are reported earnings per share. These are calculated using Generally Accepted Accounting Principles (GAAP). The biggest problem with reported earnings per share is that there are many ways to manipulate them. I will not go into details in this article but some of the ways may be selling off a large piece of property and then accounting for it as operating income or a more common method would be the company buying back its own shares.
So even though these earnings per share are reported, they still do not give the purest answer to what the earnings per share is. So lets dig a little deeper into the subject.
Ongoing Earnings Per Share
Ongoing earnings per share helps to address some of the issues but not all of them. This formula would exclude irregular events that appear on the books. It would use a historical ongoing net income number to calculate the formula. Unfortunately, it would not account for the company buying back its own shares outstanding. Look at the earnings per share this way would be considered one of the ways you could derive a result using ProForma.
ProForma Earnings Per Share
ProForma is a technique in which you would make assumptions to help you derive the earnings per share. Using the situation mentioned above, if the company had sold a large piece of property it could affect the earnings per share calculations. If you do some research and find that the company has been growing its net income by 3% over the past 7 years you may decide to calculate earnings per share using the 3% increase over the previous year. Of course, this is making an assumption that the company has repeated its trend from the previous 7 years but it would allow you to exclude the income incurred from selling the property.
There is nothing definite about using the ProForma method but it can give you a different perspective than what the company has reported.
Headline Earnings Per Share
This by far can be the most deceptive earnings per share number. The reason for this is because this number can literally be any number. The person who wrote the headline may be using a number that was reported by the company. They could also be using a ProForma number reported by some analysts.
Headline earnings per share is by far the best reason why you should do your own calculations. You never know what numbers went into the equation to get the result. It could be an extremely accurate result or it could be a very distorted one. If you do the calculations yourself then you will know exactly what numbers went into the equation.
Cash Earnings Per Share
This formula will give a better understanding of a company’s true earnings per share. This equation does to include a lot of the fluff involved in other formulas but instead focuses in on the company’s operating cash flow. If ABC company generates $200,000 in operating cash flow and has 1,200,000 diluted shares outstanding the equation would look like this.
$200,000 / 1,200,000 = $0.16 cash earnings per share
By using this method you are able to circumvent some of the earnings per share manipulation using reported numbers. There are no assumptions used here like we did with ongoing earnings per share. A lot of very successful investors like using these types of formulas because it looks at the actual cash that the company generates.
Free Cash Flow Earnings Per Share
Now we have reached one my favorite metrics to look at. In a good business, they will be generating more cash than is required for operating expenses and capital expenses. This is a good thing because as the free cash flow increases the company is able to grow the business, pay down debt or to return capital to shareholders. In any of these situations it allows the company to have more flexibility financially. Let’s note that free cash flow is operating income minus capital expenditures. Continuing with our example, ABC company also has $50,000 in capital expenditures.
Free cash flow earnings per share is a very popular metric to use when evaluating a real estate investment trust. It gives you the best representation of the cash that the company is generating. This is another metric that a lot of successful investors use because of that exact reason. It is harder to manipulate the cash flow of a company than it is their earnings.
As we have seen there are many different ways that we can analyze earnings per share. It is very important that you know which one you are using when you are evaluating an investment. I like to always do my own calculations that way I know exactly what data is being used. I’m not saying that one way is right and one way is wrong. I think that all of these different metrics are useful if used at the right time.
Do you use a different version of an earnings per share matric? If so, I would love to hear about it in the comments.
As always I look forward to reading all of your comments and questions, until then….. happy investing!
-Jason from MoreDividends.com
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