Gertrude Stein once said, "A rose is a rose is a rose," but the same cannot be said about earnings per share (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 undervalued depending on the EPS being used. This article 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." There are numerous ways to define earnings, so let's start with shares outstanding.
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 and Exchange Commission (SEC). 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 10-Q, 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.
The 5 Types Of Earnings Per Share
Shares outstanding can be classified as either primary or standard (primary EPS), or fully diluted (diluted EPS). Primary EPS is calculated using 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. It is written as: (income - dividends paid on preferred stock) / (outstanding shares).
Diluted EPS entails a complex calculation that determines how many shares 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. nvestors tend to prefer diluted EPS because it is a more conservative number. 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 the 10-Q or 10-K.
The Financial Accounting Standards Board, or FASB, requires public companies to list both versions in their financial statements. 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 the focus. (For more insight, see Getting The Real Earnings.)
Types of EPS
There are five 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 SEC 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, see Footnotes: Start Reading The Fine Print.
Ongoing/Pro Forma 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.
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.
Carrying Value/Book Value EPS
Carrying value per share, more commonly referred to as book value of equity per share or BVPS, measures the amount of company equity in each share. Focusing on the balance sheet and not much else, it is considered a very static representation of company performance. Nevertheless, the general trend of carrying BVPS can tell the investor a lot about how effective management is at increasing shareholder equity. BVPS should tell the investor how much his shares would be worth if the company had to be liquidated and all of its assets sold. It might be interesting to note that Benjamin Graham and Warren Buffett consider BVPS to be one of the most important company measures.
Calculating retained earnings per share involves taking net earnings, adding any currently held retained earnings, subtracting the amount of dividends paid out and dividing the remaining amount by the number of outstanding shares.
Retained earnings is the amount of profit that is kept by the company rather than being sent to stockholders in the form of dividends. The amount of any retained earnings not spent in a given period is added to net earnings of the following period to make the retained earnings calculation for that period. In other words, retained earnings refers to the accumulated profit 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, and is subtracted from net earnings in the following period.
Retained earnings can be used for such things as paying off debts and reinvesting in the company in ways that can generate future income, such as salaries for new employees, buying equipment or expanding operations. Or they can simply be kept as a reserve.
Knowing how much profit to use to pay dividends and how much to keep as retained earnings – and how to use it – is part of good business management. The amount depends on the age and cash requirements of the company, the amount of accumulated retained earnings and how much profit the company is currently making. Comparing the amount of retained earnings per share over time can help determine if a company is handling its profits wisely.
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, 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 recent GAAP rule (FAS 142), which allows companies to stop amortizing goodwill. Companies may start talking about "cash EPS" in order to differentiate between pre-FAS 142 and post-FAS 142 results; however, 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.
Tutorial: How to Analyze Earnings
The Bottom Line
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.
(For more on how companies can skew their results, read 5 Tricks Companies Use During Earnings Season.)