How to evaluate the quality of EPS

It is difficult to interpret the actual meaning of a company’s earnings per share (EPS) report. Most importantly, management can manipulate earnings per share numbers in a variety of ways to their advantage. This article will show you how to evaluate the quality of any type of earnings per share to understand what it tells you about stocks and potentially protect your interests as an investor.

Overview

The evaluation of earnings per share should be a relatively simple process, but due to the magic of accounting, it can become a smoky game, accompanied by a constantly changing version that seems to come out of “Alice in Wonderland.” After some in-depth consideration of the direct costs, indirect costs, and EBIT of the income statement, we have GAAP and non-GAAP earnings per share data instead of Tweedle-Dee and Tweedle-Dum. Investors usually get to know these expectations through previous guidance, whisper numbers, or consensus points, but they will never know the true numbers before the report is released.

To be fair, the ambiguity of the EPS report cannot be entirely attributed to management. Wall Street should also be blamed for its recent short-sighted attention and its knee-jerk reaction to 1 cent mistakes. Predictions are always just guesses—no more and no less—but Wall Street often forgets this. However, this can create opportunities for investors who can assess the quality of long-term returns and take advantage of market overreaction.

What is EPS?

Before you can analyze the quality of EPS, it is important to make a simple breakdown of what EPS is. EPS is the bottom line of the income statement, showing the company’s total net income divided by its outstanding shares. The income statement is usually divided into four parts. First, look at the direct costs of companies that contribute to net income and gross margin. Second, look at the indirect costs that lead to operating income (also known as earnings before interest and taxes (EBIT) and operating margin). The third is the net income of the company after deducting interest and taxes from EBIT. Finally, the earnings per share breakdown.

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The last part of the income statement focuses on earnings per share, decomposing earnings in two ways. Listed companies report basic earnings per share and diluted earnings per share. Basic earnings per share is usually net income divided by free float, stocks that are active in the market. Diluted earnings per share is net income divided by the total number of available shares, including free float and convertible shares. Companies and the media usually focus on diluted earnings per share.

The earnings per share portion of the income statement is often adjusted based on non-GAAP measures. Companies can manipulate EPS numbers through their stock management or adjustments using non-GAAP items.

EPS quality

High-quality earnings per share may mean that this number is a relatively true representative of the company’s actual income. This is usually accompanied by few non-GAAP earnings adjustments. It may also involve the company’s revenue recognition strategy. Revenue recognition strategies vary by industry and company. These strategies are easy to overlook, but it is important to understand these strategies when assessing EPS quality. When a company is improving its expense management and increasing profit margins, EPS may also be considered to be of higher quality.

Higher fees, a large number of non-GAAP adjustments, and unnecessary changes in outstanding shares may be signs of low-quality earnings per share reports. The management can change the stocks in circulation through new issuance and repurchase. Accounting standards also stipulate the degree of freedom in the field of income recognition. Nonetheless, companies must comply with ethical standards in EPS reports. Working outside of revenue recognition standards may lead to management issues and litigation, as in the cases of Enron and WorldCom.

How to evaluate the quality of EPS

EPS is a by-product of company earnings, so in general, there are several ways to evaluate EPS. Viewing the income statement is important to understand the company’s expenses and how they are managed. Gross profit margin, operating profit margin, and net profit margin are all helpful in evaluating expenses at different stages of the income statement.

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Using comparisons can also help assess EPS quality. The isolated earnings per share figure is simply the result of the company’s reported income minus expenses divided by the number of shares outstanding at any given time. Therefore, it may be important to look at EPS from a different perspective. Some investors subdivide earnings per share into similar to profit margins, so they can look at net income per share or earnings per share from continuing operations. It is also important to look at EPS growth and compare EPS across the industry. If earnings per share soar or grow much higher than comparable companies, you should explain why.

Investors may also turn to cash flow statements and operating cash flow, especially some analysis of the quality of earnings. Some investors analyze operating cash flow and operating cash flow per share compared to earnings per share. Generally speaking, investors want to seek operating cash flow higher than earnings per share.

In general, if a company’s earnings per share grow without increasing operating cash flow or operating cash flow is negative, then this may be a sign. In some cases, this may mean high operating expenses that may come from unrealized revenue receivables. This may also be the result of long-term high levels of depreciation or amortization. Negative operating cash flow may also require more in-depth analysis of debt levels, number of days of outstanding sales, and inventory turnover. As the saying goes, “cash is king”, so if there are some challenges in operating cash flow, and income grows steadily or at a faster rate than in the past, this may be worrying.

Trends are important

As mentioned earlier, it may be important for investors to view earnings per share from a different perspective. Therefore, the trend may be an important factor in the analysis. Due to the macro variables that affect the entire industry, the earnings per share growth of the entire industry may increase or decrease. Due to new product launches or increased capital expenditures, companies may also catch up or lag behind trends. Compared with future earnings per share expectations, the company may also report a decline in pro forma operating cash flow. There are many factors that affect the company’s earnings per share analysis, industry earnings per share growth, and operating cash flow. In some cases, the company may also have a low or high quarter due to new strategic investments or special factors.

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Evaluating trends helps to discover different types of scenarios. In some cases, differences and downward trends may be justified (economic cycle, the need to invest in future growth), but if the company is to survive, the problem will not last long.

Bottom line

A company’s earnings per share report usually attracts a lot of attention. It provides the company’s bottom-line earnings results and is one of the key indicators to measure the company’s quarterly or annual performance. Because it does attract a lot of attention, management and investors attach great importance to it. From a management perspective, executives can use various techniques to potentially manipulate earnings per share. However, investors are subject to this, so it is also important for them to fully understand what earnings per share represent and how to analyze them to achieve earnings quality.

The market as a whole is known for its efficiency. Therefore, the efficiency of the market usually leads to higher valuations for high-quality companies with profitable growth, and lower valuations for companies with declining earnings or low-quality earnings. Although management can use certain techniques to adjust earnings per share, investors and the market usually do not differ for a long period of time. The continuous decline in the quality of earnings usually leads to aggressive intervention and/or shareholder litigation to seek retaliation for ignoring the best interests of shareholders in the management’s EPS strategy.

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