FOOL SCHOOL
The Essential Guide To EPS

September 6, 2004

Earnings per share (EPS) is a key measure of a company's profitability. It can be used to assess a firm's growth, to set boardroom bonuses and to judge a share's value via the P/E ratio. However, peruse through any company's results and there is likely to be a handful of different EPS figures reported. Here's what they all mean, and what to look out for..

Shareholder profits

Defined in FRS 14, the formula for calculating EPS is: 

                      Profit/loss attributable to ordinary shareholders
Earnings per share = ---------------------------------------------------
                     Weighted average number of ordinary shares in issue

FRS 3 deems the 'profit/loss attributable to ordinary shareholders' (in a word, 'earnings') as the profit/loss produced after all operational expenses, goodwill amortisation, interest, tax, exceptional items, minority interests and preference dividends, and is used to calculate what's called basic or statutory EPS. 

FRS 14 also allows companies to calculate their own EPS figure, the numerator of which can exclude certain charges (usually goodwill amortisation and one-off costs) to present a clearer picture of progress. This second EPS figure has many names, including headline, adjusted, underlying and normalised.

However, companies must explain any alternative EPS measure. For instance, GlaxoSmithKline (LSE: GSK) notes its 'business performance' EPS '... is the primary performance measure used by management, [and] is presented after excluding merger items, integration and restructuring costs and disposals of businesses.  Management believes that exclusion of these items provides a better comparison of business performance for the periods presented.  Statutory results include these items.'

BAE Systems (LSE: BA.) provides a good example of how basic and underlying EPS figures are produced:

Year to 31 December	2003     (£m)	2002    (£m)
Turnover	8,387	8,076
Operating profit	980	1,002
Goodwill amortisation and impairment	(518)	(615)
Exceptional items	(9)	(797)
Net interest	(220)	(206)
Taxation	(225)	(70)
Profit/(loss) after tax	8	(686)
Equity minority interests	(2)	-
Profit/(loss) for the financial year	6	(686)
Dividends:
Equity: ordinary shares	(281)	(281)
Non-equity: preference shares	(21)	(21)
Basic earnings/(loss) per share (p)	(0.5)	(23.2)
Earnings/(loss) per share excluding goodwill amortisation and impairment and exceptional items (p)	16.6	17.3

Note BAE Systems reported a £6m 'profit for the financial year' for 2003 yet registered a 0.5p loss per share. The latter was calculated after accounting for the £21m dividend for its preference shares.

Companies must reconcile the difference between the basic EPS figure and any alternative EPS in their accounts. The next table shows BAE System's reconciliation:

Year to 31 December	2003            (£m)	2003 (per share)	2002           (£m)	2002 (per share)
Profit/(loss) for the financial year	6		(686)
Preference dividend	(21)		(21)
	(15)	(0.5)	(707)	(23.2)
Add back:
Goodwill amortisation and impairment	518	16.9	615	20.2
Exceptional items	9	0.3	797	26.1
Tax on exceptional items	(3)	(0.1)	(177)	(5.8)
Earnings excluding goodwill amortisation and impairment and exceptional items	509	16.6	528	17.3

Importantly, determining 'adjusted' profit figures is an accounting art and therefore the relevant EPS figure can be open to abuse. Though goodwill amortisation is usually seen as a genuine adjustment, other write-offs and exceptional items should always be inspected. Large and/or recurring exceptional charges ought to be treated with suspicion.

Shares in issue

The denominator in the EPS calculation is the weighted average number of shares outstanding during the period under review. Annual reports must include an accounting note that declares the share number used.

The following is extracted from the 2003 annual results of Man Group (LSE: EMG): 'The calculation of basic earnings per ordinary share is based on a profit for the year of £234.5 million (2002: £152.1 million) and 292,984,011 (2002: 258,439,772) ordinary shares, being the weighted average number of ordinary shares in issue during the year after excluding the shares owned by the Man Group plc employee trusts.'

Note that weighted share counts often change from year to year. Events such as share buybacks, the exercise of options and bonus/rights issues will affect the number of shares in issue. Back to Man's 2003 results:

Year to 31 March 2003	Total share count (m)	Weighted average share count (m)
Number of shares at 1 April	267.2	267.2
Issue of shares - acquisition of RMF	43.6	36.4
Repurchase and cancellation of own shares	(4.1)	(1.3)
Number of shares at 31 March	306.7	302.3
Shares owned by employee trusts	(9.4)	(9.3)
Basic number of shares	297.3	293.0

As a consequence, it's always worth comparing the total number of shares outstanding at the year-end to the weighted average numbers used for EPS purposes. Any difference will have an effect on EPS for the current year, as will any share count changes post year-end. Man's total share count at the end of March 2003 was 1.4% greater than the weighted average seen during the previous twelve months.

Dilution

The final EPS figure every company must report is diluted EPS. This figure shows the effect of potentially dilutive securities, such as options, warrants, convertibles and so on. Big differences between the basic EPS figure and its diluted equivalent could mean future EPS growth slows as more shares come into circulation.

The profit figure for diluted EPS is calculated the same as before, altered only for the money the company saves/receives following the exercise of the dilutive securities. The financial effect in this respect is usually minimal.

However, the dilutive effect on the share count can be significant. Man's 2002 results again: 'The diluted earnings per share is based on a profit for the year of £238.5 million (2002: £152.1 million) and on 314,327,270 (2002: 267,656,898) ordinary shares'. Though the profit figure has increased slightly (£234.5m to £238.5m, up 2%), it was more than offset by the increase in shares (293m to 314m, up 7%). It all meant underlying 2003 EPS was some 5% greater than the diluted equivalent (63.8p vs. 60.7p).

Beware, too, that not all dilutive shares are included in the diluted EPS calculations. 'Out of the money' options for instance are excluded. It's therefore worth finding out the total number of potentially dilutive shares in circulation. Man again: 

Year to 31 March 2003	Total share count (m)	Weighted average share count (m)
Basic number of shares	297.3	293.0
Share awards under incentive scheme	9.4	9.3
Employee share options	1.3	0.1
Exchangeable bonds	31.2	11.9
Dilutive number of shares	339.2	314.3

The total number of dilutive shares is some 16% higher (339m vs. 293m) than the weighted average used in the basic EPS calculation. Man shareholders could thus face a notable dilution and see EPS growth slowing if all the various share awards and exchangeable bonds were exercised.

Summary

The two key EPS points to remember are:

* Determining 'adjusted' profit figures is an accounting art and therefore the relevant EPS figure can be open to abuse, and;
* Big differences between the basic EPS figure and its diluted equivalent could mean future EPS growth slows as more shares come into circulation.