Understanding The Truth Behind EPS

One of the most important questions anyone who is concerned about investing in equities is should be asking is "How much money are you going to make for me?" Although other questions are generally ancillary to this first question, the next logical question is validating the "strength" of these earnings as a measure of where the price of the stock should be.

Earnings per share (EPS) is a good measure of a companies performance because it is a fairly no nonsense indicator of how much the company is making (and by extension, how much of that is yours). But manipulation by management can often obscure problems which may not be obvious by just looking at this number.

The first place an analyst will go is to check the actual EPS versus the guidance. If the actual EPS is below management guidance, the assumption is that either the management isn't doing there job, or there is something wrong with the business (it is analogous to not being able to collect your rent every month). Perceived problems have negative effects on a stock's price. Usually, EPS above guidance comes as a welcome surprise (think Apple's recent quarterly earnings report and the subsequent jump in price).

[Aside: It is also interesting to note that when discussing Apple's stock, analysts will usually focus on iPhone sales and sometimes neglect the impact of other divisions (Macbook or iTunes sales for instance). This is a danger when evaluating any company (especially those with exposure in different segments). This is particularly pervasive in mining where companies will mine for different resources and therefore have different exposures to commodities prices. There's an old Chinese Maxim: "Don't focus on a scorpion's head at the expense of the tail."]

In order to calculate a price for the stock, a quarterly EPS is aggregated with other EPS in the year to form a trailing 12 month EPS. Then an appropriate PE ratio (determined by similar companies in the industry and tweaked for unique characteristics of this company) is used to create a price for the companies stock.

Now that we've looked at how EPS and PE interact to form a stock price, let's look at where extra care needs to be taken.

Although annual reports are audited by third parties (and come with hints as to whether they are qualified or unqualified), quarterly EPS can be greatly influenced by management manipulation of non-recurring expenditures or sales of assets (a good place to look for indications of this are in the MD&A). For example: Selling a factory might increase EPS by +2c which may not seem like a lot, but could be the difference between "falling short" (actual EPS 39c) versus "making the numbers" (expected EPS 41c). Other categories of non-recurring items include exercising deferred tax assets/liabilities, selling/buying marketable securities or acquiring another company at a discount/premium. Under the guise of "proof smoothing" or outright attempts to mislead the public by less scrupulous executives, a prudent analyst will critique EPS numbers to understand what's recurring, what's growth and what is obfuscation.

Also, some companies who are experiencing tremendous growth might be in a position to sacrifice short term earnings for huge profit potential in the future (negative EPS as a precursor to large EPS growth - how long term investing by the company manifests on financial statements by using large amounts of capital to purchase revenue generating assets). However, in this case, it is particularly important to look at the Weighted Average Common Shares outstanding. A negative EPS is a dangerous place to be. And it might appear that a small negative EPS is less risky than a large negative EPS. However, a small negative EPS may simply be a huge loss spread over a large number of shares (further compounding the difficulty of recovery).

What I am proposing is simply this: Looking only at the basic information (trailing EPS, FPE, PEG, yield etc) provided by the popular public stock research tools (Google or Yahoo Finance, Reuters or Bloomberg) is only a mechanically generated *part* of the story. Especially when times are tough, it becomes even more essential to do your homework and use the appropriate performance forecasting metrics.