by Juan Leer

Created on: May 23, 2008   Last Updated: July 04, 2009

If you are dealing with the financial world or investing at all, the earnings per share of a company will be an important number for you. Earnings per share is a fairly simple calculation for those in the financial field, but it provides vital information for investors as it serves as an important indicator of a firm's profitability. But while it is fairly easy to calculate and easy to look up on a financial statement, it's important to be able to understand how it's calculated and why it is so important to investors. The first thing to understand is that there is the simple basic earnings per share, as well as dilutive earnings per share.

First, basic earnings per share. This is calculated by taking a firm's (Net Income - the Dividends on Preferred Stock) divided by the Average number of Common Shares Outstanding. It might also better to find the weighted average of the common shares outstanding, because this will provide a more accurate EPS amount, but many companies just simplify it by finding the average amount of common shares outstanding (which is just the end amount + the beginning amount divided by 2).

Dilutive EPS includes all of those securities that could have options or warrants which could be exercised. For example, if there is a number of bonds that can be converted into stock, the Diluted EPS would take into account what would happen if the bonds actually were converted. This just helps to give investors more information as to how stable the EPS number is.

Most financial analysts think that EPS is the single most important variable used in determining a share's stock price. Another important use is that it is used calculating a firm's P/E Ratio (Price to Earnings Ratio), which is also important to investors.

However, investors must be strongly cautioned to look beyond just EPS, and use it only as a guideline and a tool to be used among other things. There are a couple of reasons for this. One is that it doesn't take into account how efficiently a firm is using its resources and capital. Depending on the amount of capital that a firm has, two firms may have the same EPS but one may be much more efficient as using their resources than another firm.

Another reason is that it can be easy for firms to manipulate the EPS number depending on how they do their calculations and estimates. Firms can do things in the short-term that can make Net Income higher, and thus make EPS higher. It's important to use EPS as a tool for investing, but it needs to be used in conjunction with other items on the financial statement.

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