The math for earnings per share (EPS) seems simple enough: Divide net income by the number of shares outstanding; that's it. But at least five variations of EPS are being used these days--from GAAP EPS to retained EPS--and an investor needs to understand what each represents to make informed decisions about stocks.
Due to the different variations in EPS, the EPS announced by a company may differ significantly from what is reported in its financial statements and news headlines. Depending on the EPS used, a stock may appear overvalued or undervalued. Below, we explore five varieties of EPS and what each can tell you about a company's performance.
The 5 Types Of Earnings Per Share
Reported EPS or GAAP EPS
Reported EPS or GAAP EPS is the number derived from generally accepted accounting principles (GAAP). This is the number that is reported in SEC filings.
A company's reported earnings can even 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, causing EPS for the quarter to spike. Similarly, a company could classify a big lump of normal operating expenses as an "unusual charge," which excludes it from the calculation and artificially boosts EPS.
- Reported EPS or GAAP EPS is the earnings figure derived from generally accepted accounting principles (GAAP).
- Ongoing or pro forma EPS excludes unusual one-time company gains or losses.
- Carry value or book value EPS is the real cash worth of each share of company stock.
- Retained EPS is the amount of the earnings kept by the company rather than shared as dividends.
- Cash EPS is the actual total number of dollars earned.
Investors need to read the footnotes to see what factors are being included in those supposedly normal earnings.
Ongoing/Pro Forma EPS
Ongoing EPS is based on ordinary net income and therefore excludes anything that could be termed an unusual one-time event. The goal here is to discover the stream of earnings from core operations, meaning ongoing EPS is a reasonably reliable indicator of future EPS.
This variation is also called pro forma EPS. The words "pro forma" indicate that some assumptions had to be used in the formula. 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 its historical results, exclude the past expenses and revenues associated with that unit. This allows for an "apples-to-apples" comparison.
In reporting pro forma EPS, a company's management may choose to subtract some expenses because they are one-time costs. That distorts the company's true earnings.
Non-recurring expenses, however, are appearing with increasing regularity these days. This raises questions as to whether some companies are just fiddling with numbers to enhance their EPS.
Carrying Value/Book Value EPS
Carrying value per share, more commonly referred to as the book value of equity per share (BVPS), measures the amount of company equity in each share. This measure focuses on the balance sheet and not much else, so it is a static representation of company performance.
Nevertheless, the general trend of this number suggests how effective management is at increasing shareholder equity. The current BVPS should tell the investor how much a share would be worth if the company had to be liquidated and all of its assets sold.
Famed investors Benjamin Graham and Warren Buffett consider BVPS to be one of the most important company measures.
Calculating retained earnings per share requires taking the net earnings number, adding any currently held retained earnings, subtracting the total amount of dividends paid out, and finally dividing the remaining amount by the number of outstanding shares. That figure is the amount of profit that is kept by the company rather than being shared with stockholders in the form of dividends.
The amount of any retained earnings not spent in a given period is added to the net earnings of the following period to arrive at the retained earnings calculation for that period. In short, retained earnings are the accumulated profit that the company keeps. It is listed on a balance sheet as a line item under stockholders' equity.
There can also be a loss, which is called negative retained earnings. It is subtracted from net earnings in the following period. A company might intend to use retained earnings to pay off debts or to expand its operations in ways that generate future income. Or it can simply be kept as a reserve.
Knowing how much profit to use to pay dividends and how much to keep as retained earnings is part of good business management. Watching a company's retained earnings per share over time can help determine if a company is handling its profits wisely.
Cash EPS is operating cash flow divided by diluted shares outstanding. Cash EPS is important because it is a purer number. That is, it represents real cash earned and it cannot be manipulated as easily as net income.
A company with reported EPS of 50 cents and cash EPS of $1 is preferable to a firm with reported EPS of $1 and a cash EPS of 50 cents. Although there are many factors to consider, the company that has the cash is generally in better financial shape.
Understanding EPS Overall
As noted, EPS is the total net income divided by the number of shares outstanding. However, either of those numbers can change depending on how you define earnings and shares outstanding.
Corporate spin doctors try to focus media attention on the number the company wants in the news, which may or may not be the EPS that is reported in documents filed with the Securities and Exchange Commission (SEC).
Based on a different set of assumptions, a company may report a high EPS number, which reduces the P/E multiple and makes the stock look undervalued. The EPS reported to the SEC may result in a much lower EPS and an overvalued stock on a P/E basis.
This is why investors must read carefully and know what type of earnings are being used in the EPS calculation.
Defining Shares Outstanding
The number of shares outstanding can be stated as either primary or as fully diluted.
- Primary EPS, also called standard EPS, is the number of shares that have been issued and are held by investors. These are the shares that are currently in the market and can be traded.
- Diluted EPS is the total number of shares that would be outstanding in addition to the current ones if all exercisable warrants, stock options, and convertible bonds were converted into shares at a point in time, generally the end of a quarter.
Investors tend to prefer diluted EPS because it is a more conservative number. The number of diluted shares can change as share prices fluctuate, but generally, traders assume that the number is fixed as stated in the FCC filing.
Regulations require public companies to list both versions in their financial statements. Sometimes, diluted and primary EPS are identical, because the company does not have any options, warrants, or convertible bonds outstanding.
Companies can focus on either when talking to investors and the media, so investors need to be sure which is the focus.