Gertrude Stein once said, "A rose is a rose is a rose," but the same cannot be said about earnings per share (EPS).
You must have heard or read about the EPS specially in the result season, but that too has to be digged in deep core to get the real health feel of the company.
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 undervalued depending on the EPS being used. This note will define some of the varieties of EPS and discuss their pros and cons.
By definition, EPS is net income divided by the number of shares outstanding; however, both the numerator and denominator can change depending on how you define "earnings" and "shares outstanding". Because there are so many ways to define earnings, we will first tackle shares outstanding.
Shares outstanding can be classified as either primary (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 as stated in quarterly fillings.
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.
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 Exchanges. 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 in the Fillings, 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.
We will focus on five types of EPS and define them in the context of the type of "earnings" being used.
1. Reported EPS (or GAAP EPS)
We define reported EPS as the number derived from generally accepted accounting principles (GAAP), which are reported in 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.
2. 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.
3. 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/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 is doing or is trying to build a "rainy day fund" to smooth EPS.
4. 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/pundit that is discussing the company. Generally, sound bites do not provide enough information to determine which EPS number is being used.
5. Cash EPS
Cash EPS is operating cash flow (not EBITDA) divided by diluted shares outstanding. We think 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 and cash EPS of 100 is preferable to a firm with reported EPS of 100 and cash EPS of 50. Although there are many factors to consider in evaluating these two hypothetical stocks, the company with cash is generally in better financial shape.
The Bottom Line
There are many types of EPS being used, and investors need to know what the EPS numbers they see represents 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 may not agree with.