INVESTOR LETTER #36
What Is Earnings Per Share (EPS)? Formula & Importance
Learn what Earnings Per Share (EPS) is, how it is calculated, and why investors use EPS to evaluate profitability, compare companies, and track long-term earnings growth.
INVESTOR NOTE
A business owner thinks in decades. A speculator thinks in minutes.
Owning a Slice of a Business
Imagine you and nine of your friends own a small pizza shop together. At the end of the year, after paying rent, salaries, electricity bills, and every other expense, the shop earns ₹10 lakh in profit. Since there are ten owners, each person's share of the profit is ₹1 lakh. Public companies work in a very similar way. Instead of ten owners, they may have millions of shareholders. Earnings Per Share simply tells you how much of the company's profit belongs to each share.
Why Investors Care About This Number
When you buy a share, you are buying ownership in a business, not just a moving stock price. Naturally, you want your share of the business to earn more money every year. EPS helps answer exactly that question. If a company's EPS keeps growing year after year, it usually means your ownership is becoming more valuable.
How Companies Divide Their Profit
A company's total profit belongs to all its shareholders collectively. Since every shareholder owns a certain number of shares, the profit is divided equally across all outstanding shares. The result is called Earnings Per Share. It doesn't mean the company pays you this amount directly, but it tells you how much profit your share has helped generate.
One Business, Different Number of Owners
Imagine two restaurants each earn exactly ₹50 lakh in profit. The first restaurant has only five owners, while the second has fifty owners. Even though both businesses earned the same amount, each owner in the first restaurant receives a much larger share of the profits. The same idea applies to companies. The number of shares matters just as much as the total profit.
Growing Profit Is Good, Growing Profit Per Share Is Better
Many beginners celebrate whenever they hear that a company reported record profits. But smart investors ask a second question: 'Did each share actually earn more?' If profits increase while the company keeps issuing more and more shares, each shareholder's slice of the business may not grow very much. That's why EPS is often more meaningful than looking at total profit alone.
Think Like a Long-Term Owner
Suppose you owned a small grocery store. Every year you would want the store to earn more than it did last year. As a shareholder, your thinking should be no different. Consistently rising EPS often tells you that management is building a stronger business that creates more value for every owner.
A Single Year Never Tells the Full Story
Imagine a student who scores 95 marks this year after scoring around 50 in every previous exam because the paper happened to be unusually easy. Would you conclude that the student has suddenly become brilliant? Probably not. Businesses are similar. One year's EPS can be unusually high because of temporary events. Investors should always study the trend over many years.
The Best Businesses Rarely Grow Overnight
Companies like great trees don't become enormous in a single season. They grow steadily over many years. Businesses that increase their EPS consistently for five, ten, or even twenty years often have strong products, loyal customers, and good management.
When More Owners Join the Business
Imagine your family business is owned by four people. One day you decide to bring in four new partners. Even if the business earns exactly the same profit as before, each owner's share becomes smaller because the profit is now divided among more people. This is exactly what happens when companies issue new shares. Existing shareholders own a smaller percentage of the business.
When the Company Buys Back Its Own Shares
Now imagine the opposite situation. Some owners decide to leave the business, and the company buys their ownership back. The total profit hasn't changed, but now fewer people are sharing it. Everyone who remains owns a larger piece of the business. Share buybacks can increase EPS for this reason.
Not Every Increase Is Good News
Sometimes a company sells a building, wins a legal case, or receives a tax benefit. These one-time events can temporarily boost profits and make EPS look impressive. However, if the core business hasn't actually improved, the higher EPS may not continue in future years.
When Losses Replace Profits
If a company spends more money than it earns, its profit becomes negative. As a result, EPS also becomes negative. Young companies may experience losses while building their business, but investors should understand whether those losses are temporary or a sign of deeper problems.
Why Comparing Only EPS Can Be Misleading
A company with higher EPS isn't automatically a better investment. Large companies naturally earn more profit than smaller ones. Industries also operate differently. EPS becomes much more useful when comparing similar businesses over long periods rather than comparing completely unrelated companies.
The Number That Works Best with Others
Imagine trying to judge a person's health using only their weight. Weight tells you something, but not everything. Similarly, EPS is only one piece of the puzzle. Revenue growth, cash flow, debt, return on equity, and competitive advantages all help complete the picture of a business.
What Warren Buffett Would Probably Ask
Instead of getting excited by one year's earnings, think like a business owner. Is the company earning more for each shareholder every year? Is that growth coming from genuine business improvement? Can those earnings continue for many years? These questions matter far more than a single impressive EPS figure.
Common Mistakes New Investors Make
Many beginners buy stocks simply because the EPS looks high or because it increased sharply in one quarter. They often ignore whether profits are sustainable, whether new shares are being issued, or whether cash is actually flowing into the business. Looking only at EPS without understanding the story behind it can lead to poor investment decisions.
Questions Every Investor Should Ask
Before investing, ask yourself: Has EPS grown consistently for many years? Is the growth supported by higher sales and healthy cash flow? Has the company avoided unnecessary share dilution? Are profits coming from normal business operations instead of one-time events? Businesses that can increase earnings for every shareholder year after year are often the ones that create long-term wealth.
INVESTOR PRINCIPLE