Earnings Per Share - A Profitability Ratio

Good earnings growth does not always equate to a value investing proposition!

The earnings per share formula can be expressed as the ratio of the net annual earnings of a company to the number of shares. It is commonly abbreviated as EPS, and is sometimes referred to as a profitability ratio.

EPS = Net annual earnings / Number of shares issued
It is one of the common financial measures that all companies include in their annual reports, and is used to calculate the price earnings ratio.

The EPS ratio should not be used in isolation without considering the capital required to produce the earnings.

It is not necessarily a good value investing indicator.

The diluted earnings per share varies from the (basic) EPS formula above by including the shares of convertibles or warrants outstanding in the total number of shares.

False Impressions About EPS

Nice looking bar graphs with ever increasing EPS in company annual reports can create a false impression, as increasing earnings per share does not always equate to increasing profitability.

Two companies may have the same earnings per share ratio but one may require significantly more capital (equity) to produce the earnings.

The one requiring less capital would be considered more efficient, and hence a more likely value investing option.

Earnings Per Share Growth

I like to see the historical EPS increasing over at least the last five to ten years. More importantly, I focus on EPS growth.

EPS growth is an important number as it provides an indication of the future prospects of a company. It is usually expressed as a percentage and is then referred to as the EPS growth rate.

Compound earnings per share growth is calculated using the CAGR formula where CAGR stands for Compound Annual Growth Rate.

I focus on companies with an EPS growth rate of at least 10 per cent per year over a five- to preferably 10-year period.

Benjamin Graham, considered to be the father of value investing, used a simpler formula which took the average of the first three years EPS and compared it to the average of the last three years EPS.

((Av.Last 3yrs EPS - Av.First 3yrs EPS)/Av.First 3yrs EPS )* 100.

Using this formula, he looked for at least a 33% EPS growth rate over a 10-year period.

Ways to Grow EPS

Companies can increase their EPS by either ...

  • doing a better job at running their company - the best way!
  • buying other companies - not always a good idea as many acquisitions do not achieve what they set out to achieve
  • undertaking a share buyback to reduce the number of shares on issue - a great idea providing the shares are selling at below what they are worth when they are bought back.

However, even though the above activities may potentially increase earnings per share, they do not all necessarily improve profitability.

Return on equity is the best measure of profitability!

For example, if a company buys back their own shares at a price greater than their intrinsic value, this could have a damaging affect on profitability.

Similarly, taking over another company that has a lower return on equity than the acquiring company may increase the EPS.

But it increases the risk that management may not realize the synergies (efficiencies) that the take over was planned to achieve.

Earnings Per Share Hiccups

I find that good bargains can be found in mid-cap companies that have had a stock market historical performance of increasing EPS and that have had a hiccup in the most recent EPS report due to reasons largely out of their control.

There can be a variety of reasons why a temporary misfortune may arise, whether it be drought, currency fluctuations, spikes in fuel prices - or whatever.

The trick is to judge whether the upset is likely to be a temporary problem of limited time duration that the company can reasonably quickly recover from.

The market tends to punish smaller companies for EPS aberrations more severely than larger companies by - you guessed it - hammering the share price!

Presumably, this is because of the smaller company's perceived reduced ability to recover from the problem.

However, in most cases they do - and when they do, so does the corresponding value of my portfolio!

To Conclude

While increasing EPS is a desirable attribute of a company, I try to determine which of the three factors above is causing it and what the affect on profitability may be.

Unfortunately, when considering the effect of an acquisition or a buyback, it may take a year or two to see the how the measures impact on the return on equity. Patience is necessary.

So while increasing EPS is something companies like to crow about, it is not necessarily an indicator that the company is a value investing proposition.

The articles below examine the importance of each of the related measures in more detail.

Related Articles

Return on equity - a more reliable measure of the profitability of a company.

The PEG ratio - uses the EPS growth rate to test whether high P/E ratios of 'growth' companies indicate over-valuation.

Earnings stability - measures how consistent the earnings per share growth of a company is. High earnings stability makes the forecasting of future company earnings less problematic.

Return from Earnings per Share to Financial Ratios

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