This article is part of Morningstar.co.uk's Equity Investing Week.
Earnings per share (EPS) is often touted as one of the most important ways of measuring a stock’s worth. While it certainly has its uses it is also open to manipulation and shouldn’t be used in isolation. Investors looking to buy stock should make far more use of free cash flow when assessing the quality of a company’s earnings.
What is EPS?
EPS gauges the profitability of a company from the view of the shareholders: it is a measure of how much profit a company has generated in a given period after tax, divided by the number of shares.
There are three main types of EPS measured.
Basic EPS: This is calculated by dividing total earnings (after tax has been deducted and less any preference dividend, where applicable) by the average number of ordinary shares in issue. For example, if a company makes a net profit of £10 million and there are 200 million shares in existence, the EPS would be 5p.
Diluted EPS: This is a more complicated and accurate measure of the earnings an investor will receive if all convertible securities such as stock options, warrants, options or convertibles are exercised. As it takes into account the dilutive effects of such issuance, the EPS figure will inevitably be lower than basic EPS. Although it is a worst case scenario, it does highlight the potential dilution for a company’s shares.
Adjusted EPS: This strips out all profits and losses attributable to non-core activities. It therefore excludes the effects of ‘exceptional’ items and ‘impairments’. It is often called ‘headline EPS’ as this is the number often highlighted in the company’s press release and quoted in the media. Other names used are: ‘pro-forma’, ‘normalised’ and ‘core’; these are non-statutory earnings measures as they are not based on the profit figure sanctioned by official accounting principles and regulations.
Drawbacks
One of the major drawbacks with this popular adjusted EPS measure is that a company has a lot of discretion when deciding what is and isn’t ‘exceptional’ so the figure is open to manipulation. It is therefore important to familiarise yourself with the adjustments inherent in the headline EPS figure so that you can judge for yourself whether they are worth accounting for. It is these nuances that have led to adjusted EPS occasionally being referred to as EEBS ('earnings excluding all the bad stuff').
Despite its widespread use, measures of EPS have many shortcomings when used as the primary measure of a company’s performance. This is because:
- EPS can be affected by changes in a company’s accounting policy;
- EPS yields growth percentages that can be misleading or meaningless when based on a small base or negative earnings from a prior period;
- EPS will be distorted if a company conducts a share buy-back. (When a company repurchases its own shares it thereby reduces the number of shares in issue, which automatically increases its EPS figure.)
- Although company management love to boast that they have increased EPS, it’s worth remembering that earnings should increase—this is exactly what an investor is looking for. Even placed in a savings account, an investor’s cash would earn more each year due to compound interest (admittedly not much more these days).
- EPS takes no account of a company’s debt position and financial leverage, factors that a discerning investor needs to be aware of.
- EPS can be distorted by mergers and acquisitions. (For examples, regardless of the actual value created, a deal will be earnings accretive if the acquirer's price-to-earnings ratio is greater than the target's price-to-earnings ratio, including the acquisition premium).
Given the above limitations of EPS, it’s clear that this measure should not be used in isolation.
A more useful method for assessing the quality of a company’s earnings, for example, is to look at the cash generated. Free cash flow (FCF) is one of the metrics that Morningstar’s own equity analysts will always assess as part of their analysis of a company. It measures the cash a company generates over and above what is required to sustain its present competitive position.
To find out more useful measures of analysing a company's shares, read our further education article:
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