Hot Issues
Good financial planning finally has a value: 23% more in retirement
Report reveals 'alarming' super savings stats
Anchors aweigh!
A retiree's choice: super pension or lump sum
Fundamentals for investing success
Market Update - June 2014
Messages Worth Remembering
Workforce rides the 'silver tsunami'
ATO outlines SuperStream concerns for SMSFs
Help investor's to save $82 per week
Super dollars
Market Update - May 2014
Market Update - April 2014
Federal Budget 2014-15 - Overview
Federal Budget 2014-15 - Overview of main responsibilities
Federal Budget Papers 2014-15
Keeping a close watch on contribution caps
Any changes to the Age Pension make saving through super crucial: ASAF
New insights into women and super
Articles archive
Quarter 2 April - June 2014
Quarter 1 January - March 2014
Quarter 4 October - December 2013
Quarter 3 July - September 2013
Quarter 2 April - June 2013
Quarter 1 January - March 2013
Quarter 4 October - December 2012
Quarter 3 July - September 2012
Quarter 2 April - June 2012
Quarter 1 January - March 2012
Quarter 4 October - December 2011
Quarter 3 July - September 2011
Quarter 2 April - June 2011
Quarter 1 January - March 2011
Quarter 4 October - December 2010
Quarter 3 July - September 2010
Quarter 2 April - June 2010
Quarter 1 January - March 2010
Quarter 4 October - December 2009
Quarter 3 July - September 2009
Quarter 2 April - June 2009
Quarter 1 January - March 2009
Quarter 4 October - December 2008
Quarter 3 July - September 2008
Quarter 2 April - June 2008
Quarter 1 January - March 2008
Quarter 4 October - December 2007
Quarter 3 July - September 2007
Quarter 4 of 2011
Articles
Merry Christmas 2011
Few know exactly what their true financial position is, do you?
The art of balancing bad news
How economic reality influences the market.
Market and Economic Updates  -  November / December 2011
Want to do some of your own research – no problems?
Lump sum love affair
How much money do you need to comfortably retire?
You can afford to contribute more to super but .....
10 most indebted nations
Market and Economic Updates - October / November 2011
Timeless lessons meet new challenges
Securely transferring Your information to your Planner.
Gender Gap
The 5 types of earnings per share
No more Star Trek conventions for Spock
An introduction to behavioural finance.
Market Updates - September / October 2011
The 5 types of earnings per share

Writer Gertrude Stein once said, "A rose is a rose is a rose," but the same cannot be said about per share (EPS).


While the maths 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.

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.

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 as stated in the 10-Q or 10-K.

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.

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 ASIC. 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.

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 ASIC 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.

Ongoing EPS

Ongoing EPS is calculated based upon normalised, 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.

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.

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.

By Investopedia.com | 14.10.2011

By http://www.thebull.com.au/ - for more articles like this go to The Bull's website Australia's pre-eminent news and investing site for investors and traders, covering shares, superannuation, property, financial planning strategies and more.

 



20th-October-2011