Earnings per Share (EPS)

Earnings per share show a company’s net income for a selected period on a per-share basis and are calculated as:

EPS = Net Income / Number of Shares Outstanding

Essentially, EPS is a metric that shows how many dollars of net income a company earned per share during the selected period.

There are two types of EPS: basic and diluted. Basic EPS is calculated using the current number of shares outstanding, while diluted EPS uses an increased number of shares outstanding. Diluted EPS assumes that all potential shares, such as employee stock options, have been exercised, which increases the total number of shares. We prefer diluted EPS because it is more conservative and better reflects a realistic perspective for shareholders.

Things to Watch Out For

Since the analyst community and Wall Street in general tend to focus on next-quarter EPS—forecasting EPS and then comparing it with actual results to determine whether there is a “surprise,” which in turn influences stock movements—some companies have an incentive to inflate EPS through various accounting and financing techniques. Below are some of the most common practices to watch for:

• Use of “adjusted” net income to calculate “adjusted” EPS.
  While the stated reasons may vary, the key point is that companies adjust their net income—most often upward of course—to produce a higher numerator and, consequently, a higher EPS.
• Excluding “one-off” or “restructuring” expenses.
  Investment history shows that few items appear in financial statements with as much regularity as those labelled “one-off.”
• Including proceeds from the divestment of assets in net income.
  This can produce a significant increase in EPS, even though such gains are non-recurring in nature.
• Capitalizing operating expenses to increase net income and EPS.
  One common example is IT development costs, which often require judgment to distinguish between operating expenses and capital expenditures. Be cautious when most or all IT (or similar) expenses are treated as CAPEX.
• Systematic use of aggressive leverage (debt) to finance share buybacks.
  This reduces the number of shares outstanding and can gradually increase EPS. In some cases, this strategy may work if (a) the cost of leverage is low, (b) overall leverage levels are not excessive, and (c) the intrinsic value of the stock is above its current market price. However, when applied regularly without discipline, this approach can lead to an overleveraged capital structure that is dangerous for long-term shareholders.

How to Deal With It

We prefer using diluted EPS calculated based on fully diluted net income in accordance with IFRS or GAAP. If there are significant year-over-year swings in EPS that cannot be reasonably attributed to operational performance, additional normalization may be required. This helps arrive at a more representative average EPS and EPS growth rate, which can then be used to assess financial performance or in valuation metrics such as the P/E ratio.

Some examples of companies with a strong track record of steady EPS growth over time:

1. Cintas Corporation - CTAS
2. Costco Wholesale Corp - COST
3. Visa Inc - Visa
4. Mastercard Inc - Mastercard

Assuming relative valuation is justified and not excessive, growth in earnings per share normally results in an increase in share price. Here is an example: Visa has grown its EPS by 312% over the past 10 years, while its stock price has increased by 360% as of the date of this writing:

Free Cash Flow per share shows a company’s Free Cash Flow for a selected period on a per-share basis and is calculated as:

FCF per share = Free Cash Flow / Number of Shares Outstanding,

where Free Cash Flow is Cash From Operating Activities less CAPEX (capital expenditures).

Essentially, this is a measure of how much free cash flow the business is generating per share. This measure is more conservative than Earnings Per Share because:

• a) Free Cash Flow is calculated after subtracting Capital Expenditures, and
• b) it is harder for companies to manipulate Free Cash Flow using accounting gimmicks that are sometimes applied to inflate earnings per share.

For stable and relatively large businesses with predictable capital expenditures, we prefer Free Cash Flow per share to Earnings Per Share as a metric, since it is more reliable in assessing business earnings power, liquidity, and capacity for dividends.

The exception would be companies with significant Capital Expenditures that are above the historical average for the business and are expected to generate payback in the future. In such cases, free cash flow per share would normally be much lower than earnings per share, and the key question for the investor is whether such significant capital expenditures are justified and will result in an adequate return on invested capital and increased earnings per share.

For example, this situation is relevant for big tech investors in 2026–2027. Let’s take Microsoft—the company has delivered fantastic performance over the past 10 years, increasing its earnings from 1.48 USD per share in 2015 to 13.64 USD per share in 2025, representing a compound growth rate of 21% and a total increase in earnings per share of 549%. The stock price followed, increasing by approximately 740% over the same period. However, its free cash flow per share over the same period increased by only 207%, mostly due to significant capital expenditures in 2023–2025.

For the time being, this was acceptable to investors, as Microsoft kept its Capital Expenditures relatively predictable at around 20–26% of Cash From Operating Activities during 2015–2022, while generating high returns on invested capital that supported earnings per share growth. However, during 2023–2025, CAPEX reached 32%, 37%, and 47% of CFO.

At such levels, this inevitably raises questions about how justified this increase is and how sustainable it will be. Another consequence is that the stock price becomes less resilient—since the company needs to deliver significant growth in earnings per share to justify such CAPEX, any slowdown in revenue or earnings growth increases the likelihood of a stock price decline, which occurred in early 2026.

Ideally, free cash flow per share should increase steadily at a rate similar to earnings per share—this reflects a business’s ability to grow earnings with predictable relative levels of capital expenditures. Usually, this results in a steady increase in share price over time.

As Warren Buffett puts it, the best type of business is a “compounding machine”—a company that can consistently reinvest high amounts of incremental capital at very high rates of return over an extended period, where each dollar used to finance growth creates more than a dollar of long-term market value.

Things to Watch Out For

• Significant differences between earnings per share (EPS) and free cash flow per share, including their growth rates over time. This may not be a red flag for one or two years when, for example, a business is investing in new prospective projects. However, when such differences persist over time, it is important to assess whether earnings calculations are normal and not inflated, and whether capital expenditures are reasonable and generating an adequate return on invested capital.
• Overstating the useful life of assets, thereby reducing depreciation and amortization. Companies with high capital expenditures (CAPEX) face the challenge of depreciating these investments over the useful life of the assets, which reduces earnings since depreciation is an expense reflected in the profit and loss statement. By unreasonably extending the useful life of assets, companies can minimize this expense in the P&L.
• Inadequate disclosure of significant past CAPEX and returns on invested capital. If CAPEX is substantial but the company does not provide sufficient detail, this should be considered a red flag for long-term investors.
• Low returns on invested capital (ROIC). If the return on invested capital is lower than the cost of capital used to finance those expenditures, such investments destroy shareholder value.
• Underinvestment in operations. On average, CAPEX should be equal to or greater than depreciation due to inflation effects. If a company underinvests, it may temporarily boost free cash flow per share, but risks leaving the business with obsolete assets, which can negatively impact long-term earnings potential.

How to Deal With It

Look for companies that: a) demonstrate a steady increase in free cash flow per share, without significant divergence from earnings per share; and b) consistently show an ability to invest capital at high rates of return, resulting in sustained growth in both earnings and free cash flow per share.