Earnings per share is a useful measure -- as long as you know its limitations.
Earning per share (EPS) is a key ratio in attempting to value a share. However, too many investors seem to have an almost fetishistic belief in it, without being aware of its limitations and the ways it can be manipulated to make a company look attractive.
What is EPS?
EPS shows how much of a company's profits, after tax, each shareholder owns. There are a few different types:
Basic EPS is calculated by dividing total earnings by the number of shares issued by the weighted average number of ordinary shares in issue during the period in question. For example, if a company makes a post-tax profit of £10 million and there are 50 million shares in issue, the EPS would be 20p.
Earnings are normally shown for the previous year, based on actual data, but can be estimated for the current year or a future year.
What is theoretically an easy calculation becomes complicated because the rules on what constitute earnings are open to interpretation, especially when it comes to 'exceptional' items, which are supposed to be one-offs, and 'impairments'. Various financial reporting standards have tried to regularise treatment of one-offs, with limited success.
Adjusted EPS (also known as 'headline earnings') is often used when a newspaper reports a company's EPS. This strips out all profits/losses attributable to non-core activities.
Diluted EPS shows the effect of potentially dilutive securities, such as options, warrants, and convertibles and so on. If there is a large difference between the basic EPS figure and its diluted equivalent, it could mean future EPS growth will slow as more shares come into circulation.
Drawbacks
Despite its ubiquity, EPS has many shortcomings when used as the primary measure of business performance. As a performance measure it:
- can be affected by changes in the accounting policy;
- does not account for the cost of capital and capital structure of the business;
- yields growth percentages that can be misleading or meaningless when calculating growth from a small base (or from negative earnings);
- is open to manipulation by a share buy-back that increases borrowings;
- should necessarily increase in any well run company, as even if earnings were placed in a normal building society deposit account you'd expect compound interest to increase your returns;
- ignores risk and, since risk increases with increased financial leverage, the maximisation of EPS does not guarantee investors will eventually benefit; and
- can be distorted by mergers and acquisitions. For example, when one company uses its more highly-rated shares to acquire another company on a lower price-earnings ratio. If the company purchased is large enough, the result can be a substantially increased EPS -- even if the earnings of both companies remain exactly the same.
Other measures
Because of the limitations of EPS, you need to conduct further research into any business to determine its quality, as well as questioning how the EPS figures that a company is putting out have been derived, before investing.
As an indication of financial health you should examine whether the business generates sufficient cash to service any debts and pay a dividend. The ratio I would use is free cash flow, which is normally defined as operating cash flow minus capital expenditure. You should then compare this figure to the cost of any debt.
Warren Buffett's favourite ratio is Return on Equity (which I've written about previously), and he compares it most favourably to EPS:
"The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry etc) and not the achievement of consistent gains in earnings per share."
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