We often hear experts saying, “buy and hold companies which are showing earnings growth.” Or “Buy stocks which have been driven by earnings”.
Earnings of a company mean nothing but the net profit after taxes and minority interest and EPS means Earnings per share available to the equity share holders of the company for each share held after all other external stakeholders have been paid/accounted for. Before investing, analyzing earnings both past and future is the most important aspect of fundamental analysis. Analysis of earnings gives the perspective about companies’ future growth and ability to pay a dividend. (Thing to remember: Earnings and revenue are two different things and serves different purposes.)
It is important to check weather earnings of the company are growing or not but finding out the cause of earnings growth or de growth is even more important.
How to calculate EPS –
Calculating EPS is very simple and is also readily available on the reported financials of every listed company.
Net profit after tax can be calculated by deducting 1) cost of sales, 2) operating expenses, 3) Depreciation and amortisation and 4) Taxes from total sales.
Easier way to calculate Number of outstanding shares issued is to divide “Market Capitalization by last closing price of the stock”.
In India, the financial year is different from the calender year and the financial year starts in April and ends in March. Companies report earnings 4 times viz. first in July for quarter 1 (Q1), in October for Q2, in January for Q3 and in March, companies report full year earnings as well as earnings for Q 4.
Types of EPS –
EPS can be calculated for various periods. Such as,
Quarterly EPS – Since, companies report earnings on quarterly basis, one can calculate EPS by simply dividing “Quarterly profit by No. of outstanding shares issued”. In cyclical stocks e.g. fertilizer companies or jewellery stocks, because of the high demand in specific quarter, profits are tend to rise. Quarterly EPS helps us in analysing these companies on quarterly basis.
Trailing twelve month EPS or TTM EPS – Trailing twelve months EPS means EPS of last 4 quarters. Considering TTM EPS can be beneficial for the companies which are turning around.
For example, TTM EPS for November, 2016 will contain EPS of Q2 FY 2017, Q1 FY 2017, Q4 FY 2016 and Q3 FY 2016.
Forward EPS – Now this can be bit tricky to calculate, Analysts often use “earnings discount model” a type of financial modelling. In earnings discount model, Analysts forecast earnings growth for future and then factors in same in current EPS.
For example, If some analyst forecasts earnings growth of 22% for company A for next year, 1 year forward earning will be current EPS + (22% of current EPS).
Cash EPS – Though EPS gives us the perspective about company’s profitability, there is one more and may be most prudent type of EPS known as Cash EPS. The profitability of a company can swing due to non operative activities which may not be recurring in nature and as such may not repeat in future. In order to ascertain realistic capability cashflow per share (Cash EPS) is more relevant. Calculating Cash EPS is as simple as calculating conventional EPS.
Formula to calculate Cash EPS = Operating Cash flow / No of outstanding shares
The quality of cash flow is also important. In order to have a rational computation of Cash EPS, one should analyze the continuity of activities. If the cash flow is due to certain abnormal factors affecting performance in a particular year, the cash flow should be adjusted to the same.
EPS and Dividend payout
In order to ascertain the proportion of profits used for payment as dividend and the amount retained in business for future needs is computed by dividend payout ratio. EPS works as a denominator in computation of dividend payout ratio, the formula for which is
Dividend payout ratio = dividend per share / EPS
Higher the dividend payout ratio, the company is considered to be investor friendly.
Impact of EPS on stock Price
“Only earnings growth can drive the stock price in longer term”. This famous saying of market says all about importance of earnings / EPS.
Stock price = EPS * P/E, since EPS is integral part of price mechanism, makes huge impact on stock prices.
Limitations of EPS
EPS is helpful in comparing profitability of one company to another, but here we need to keep in mind that every sector throw different growth. One can compare EPS of two companies of same sector but it doesn’t tell you quality of stock and when to buy it.
Here we would also like to quote an extract from famed Indian Investor Bharat Shah’s book where he explains why investors should focus more on Cash Flows rather than Accounting Profits (i.e. EPS)
“Cash Flow is the only enduring reality: Accounting Profits and PE Multiples are Popular, but Unreal, Pastimes.
There is too much attention paid to, and obsession with, profits reported rather than cash flows and too much attention paid to Profit and Loss statement to the exclusion of Balance sheet. Cash flows over time (not just period cash flows) are a more valuable guide to what is happening to the business than accounting profits. Profit and loss statement, without studying Balance sheet, can provide misleading impressions of the financial health of a business.
Eventually, value creation is intimately (if not solely) linked to the cash flows generated over the useful life of a business. What one is paying out today is the hard cash in terms of the market price of a business and what will eventually get over a period of time in form of a return also has to be hard cash. The equation which equates the cash outflow today with cash inflows over a period of time, will determine the productivity of that investment; in other words, these cash inflows and the resultant IRR are the only reality.
Accounting profits often are an illusion, based on how the non-cash charges are treated: converting expenses ( a revenue item) into a capital item and even vice versa, how the inventories are treated and valued and also sometimes by making creative year-end entries to puff up (or depress) profits. Accounting profits can, at best, give a glimpse into the real affairs of a business, while the only reality is the cash flow. India produces legions of ‘crafty’ and ‘creative’ accountants. So, profits reported by firms need to be dealt with due skepticisms.
Equally, measuring rod cannot be a one year’s profit (which in itself is an inadequate number) compared with today’s price. This approach has two lacunae a) focus on profit and not cash flow and b) focus only on a single year while business (hopefully) is for a lifetime. Hence, PE ratio is one of the simplest but one of the most deficient ways of measuring value which can deflect attention from the reality and present a superior or inferior picture than what it really is. Which means a low PE at times could be hiding a potential lurking problem in the future and a high PE sometimes may blind oneself in duly recognizing an opportunity waiting to happen. Correlating, only immediacy with a ‘weak’ data point like accounting profits, is two deficiencies mixed up together and that can only produce a very dissatisfying result. Immediacy often is a mirage while cash flow is the only reality.
There is also a conceptual infirmity, when value ascertainment is made on the basis of ‘forecast’ or ‘judged’ PE target. That results in an ironic situation of deriving value based on ‘targeted’ PE while PE itself is derived once a judgment of value is made. PE cannot determine value; it itself is determined when a good judgment of value is made.
The only real measurement is how much cash flow one has laid out to purchase a business (that is complete determinate) and what kind of cash flows are thrown up over a period of time (which is a conjecture). While accounting profits are relatively more susceptible to tweaking and not always easy to detect, especially, over short periods. It is much harder to fudge the cash flows. It will show up somewhere or the other and can easily be detected by careful analysis. Cash flow is a motherhood test since it is a matter of reality, while accounting profit is a fatherhood idea, at best a matter of belief.
One is not saying that free cash flows (FCF) have to be generated over every single period or every single year. A particular period, because of capex or certain specific conditionality, may not witness FCF. But a business has to generate FCF over every reasonable period of time and material FCF over its lifetime, for it to create value. More stringently, a business has to generate operational cash flows (OCF) (after meeting requirement of incremental working capital but before capex) in virtually every single period or year (barring some exceptional one-off period). That is a must for value creation.
Challenge is to evaluate or understand whether these cash flows are sustainable and meet the IRR requirements of the investors. Only those businesses, that have ability to generate superior OCF and meaningful FCF, can grow in a sustainable manner and without much capital dilution, can have enhanced ability to fund the growth, can sustain higher dividend payouts and create real value. These businesses have rightly seen increasing PE multiples in the past.”
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