By definition, EPS is net income
divided by the number of shares outstanding, The math may be simple, however,
both the numerator and denominator can change depending on how you define
"earnings" and "shares outstanding."
There are numerous ways to define
earnings, so let's start with shares outstanding.
A . Shares Outstanding
Shares outstanding can be
classified as either primary, or basic, (primary EPS) or fully diluted (diluted
EPS). Primary EPS is calculated using the number of shares that have been
issued and held by investors. These are the shares that are currently in the
market and can be traded.
Diluted EPS entails a complex
calculation that determines how many shares would be outstanding if all exercisable warrants,
options, etc. were converted into shares at a point in time, generally
the end of a quarter. Diluted EPS is preferred, because it is a more conservative number that
calculates EPS, as if all possible shares were issued and outstanding. The
number of diluted shares can change as share prices fluctuate (as options fall into/out of the money), but generally the
Street assumes the number is fixed.
Companies report both primary and diluted EPS
and the focus is generally on diluted EPS, but investors should not assume this
is always the case. Sometimes, diluted and primary EPS are the same, because
the company does not have any "in-the-money" options, warrants or convertible bonds
outstanding. Companies can discuss either, so investors need to be sure which
is being used.
B. Earnings
As a general rule, EPS can be
whatever the company wants it to be, depending on assumptions and accounting
policies. Corporate spin doctors focus media attention on the number the
company wants in the news, which may or may not be the EPS reported in
documents filed with the Securities Commission (SC). Based on a set of
assumptions, a company can report a high EPS, which reduces the P/E multiple
and makes the stock look undervalued. The EPS reported, however, can result in
a much lower EPS and an overvalued stock on a P/E basis. This is why it is
critical for investors to read carefully and know what type of earnings is
being used in the EPS calculation.
C. EPS
While the math may be simple,
there are many varieties of EPS being used these days and investors must
understand what each one represents, if they're to make informed investment
decisions. For example, the EPS announced by a company may differ significantly
from what is reported in the financial statements and in the headlines. As a
result, a stock may appear over or under-valued depending on the EPS being
used. This article will define some of the varieties of EPS and discuss their
pros and cons.
There are five (5) types of EPS to
be defined in the context of the type of "earnings" being used:
Reported EPS (or GAAP
EPS)
We define reported EPS as the number derived from
generally accepted accounting principles (GAAP), which are reported in SC
filings. The company derives these earnings according to the accounting
guidelines used. A company's reported earnings can be distorted by GAAP. For
example, a one-time gain from the sale of machinery or a subsidiary could be
considered as operating income under GAAP and cause EPS to spike. Also, a
company could classify a large lump of normal operating expenses as an
"unusual charge," which can boost EPS because the "unusual
charge" is excluded from calculations. Investors need to read the
footnotes in order to decide what factors should be included in
"normal" earnings and make adjustments in their own calculations. (To
learn more about what can be found in the footnotes).
Ongoing EPS
Ongoing EPS is calculated based upon normalized, or
ongoing, net income and excludes
anything that is an unusual one-time event. The goal is to find the
stream of earnings from core operations, which can be used to forecast future
EPS. This can mean excluding a large one-time gain from the sale of equipment,
as well as an unusual expense. Attempts to determine an EPS using this
methodology is also called "pro forma" EPS.
Pro Forma EPS
The words "pro forma" indicate that assumptions were used to
derive whatever number is being discussed. Different from reported EPS, pro
forma EPS generally excludes
some expenses or income that were used in calculating reported earnings.
For example, if a company sells a large division, it could, in reporting
historical results, exclude the expenses and revenues associated with that
unit. This allows for more of an "apples-to-apples" comparison.
Another example of pro forma is a company choosing to
exclude some expenses, because management feels that the expenses are
non-recurring and distort the company's "true" earnings. Non-recurring
expenses, however, seem to appear with increasing regularity these days. This
raises questions as to whether management knows what it's doing, or is trying
to build a "rainy day fund" to smooth EPS.
Headline EPS
The headline EPS is the EPS number that is
highlighted in the company's press release and picked up in the media.
Sometimes it is the pro forma number, but it could also be an EPS number that
has been calculated by the analyst or pundit that is discussing the company.
Generally, sound bites do not provide enough information to determine which EPS
number is being used. (For more on how companies can skew their results, read 5
Tricks Companies Use During Earnings Season.)
Cash EPS
Cash EPS is operating cash flow (not EBITDA) divided
by diluted shares outstanding. Generally, cash EPS is more important than other
EPS numbers, because it is a "purer" number. Cash EPS is better
because operating cash flow cannot be manipulated as easily as net income and
represents real cash earned, calculated by including changes in key asset
categories, such as receivables and inventories. For example, a company with
reported EPS of 50 cents and cash EPS of $1 is preferable to a firm with
reported EPS of $1 and cash EPS of 50 cents. Although there are many factors to
consider in evaluating these two hypothetical stocks, the company with cash is
generally in better financial shape.
Other EPS numbers have overshadowed cash EPS, but we
expect it to get more attention because of the new GAAP rule (SFAS 142), which
allows companies to stop amortizing goodwill. This version of "cash
EPS" is more like EBITDA per share and does not factor in changes in
receivables and inventory. Consequently, it may not be as good as
operating-cash-flow EPS, but is better in certain cases than other forms of
EPS.
D. Conclusion
There are many types of EPS being used and investors
need to know what the EPS numbers they see represent and determine whether they
are a good representation of a company's earnings. A stock may look like a
great value because it has a low P/E, but that ratio may be based on
assumptions which, upon further research, you might not agree with.
