Earnings Per Share
A common
indicator and approach to stock market investing is the looking at the profits
earned by the company. We generally tend to compare it over a period of time
that includes year on year, quarter on quarter etc. But is it right? Is it
correct? Are we on the right track? Well, the answer is yes and no. No doubt
the profits earned by the company are a way to gauge its performance over a
period of time but it never gives a complete picture. While analyzing and
comparing the profits of company, we should also take note of the industry
performance and performance of the peers /competitors in the strategic group.
For the purpose of simplicity, strategic group are companies having similar
nature of businesses. Take for example, Tata Motors per se can be compared with
Maruti Suzuki, but the Performance of its Jaguar Land Rover division would need
to be excluded.
Now that is just
the beginning. The true indicator of performance and shareholder value creation
is the Earnings per share (EPS). It is per se a representative of the value
generated by the company’s operations to its common stockholders. The company
may be incurring profits, but the capital structure may not allow the company
to pass on the earnings to its shareholders. For the purpose of simplicity, the
capital structure represents the different sources of funds the company has used
to fund its operations / assets. In its
crude form, capital structure identifies the debt and equity structure of the
company. Some companies can have complex capital structure that would involve
hybrid securities, e-sops, preference shares etc.
Apart from
Earnings per share, the Next things that come to the picture are different
financial ratios like debt-equity, asset turnover ratio, profitability ratios
etc. A quick comparison with industry/peers and over a period of time shall
give a clear picture on whether to invest in a company or otherwise continue
staying or not.
However, at this
point it is important first to understand the underlying principles of EPS
EPS, in simple form is referred as the ratio of
earnings (profit after tax) generated by the company to the no. of shares of a
company in the market.
A common mistake in calculating the earnings per
share is that we generally tend to divide the earnings with the existing no. of
shareholders on a given date. This is however, not correct. Changes in the
equity structure of the company over a period of time need to be discounted
with. It is done by calculating the weighted average no. of shares. Further, companies with complex capital
structure need to declare diluted earnings per share. In case, an investor sees
both Basic Earnings per share and diluted earnings per share, it is imperative
that he/she uses the diluted earnings per share as a metric to analyze and
compare the performance.
The above guidelines,
however do not take cognizance of the accounting adjustments that companies do
to show better ratios and higher EPS. In accounting terminology, the same is
known as Earnings management and is legal as per law. This will be when the
financial statements are stated and books of accounts are adjusted for various
accounting policies within the frameworks prescribed as per Standards. This is
legal and is unlike the case in Satyam, wherein the accounts were manipulated
and fake assets were shown. These accounting policies are always declared in
the notes to accounts and are sometimes discussed in the management discussion
section of the financial reports.
To summarize, in
order to gauge a company’s performance and deciding whether to invest or not is
dependent on many factors. It includes understanding and comparing various
financial ratios and comparing the same with its peers. The most important
indicator however is Earnings per share which is value created for
shareholders. EPS calculation is complex and requires and understanding of
Companies capital structure and discounting for its accounting policies.
The next sections shall cover more on Earnings
per share followed by the cost of capital of the company and the relation to
Earnings per share.
Guest Author -
Utkarsh Khanna, MBA (Finance) ,
Indian Institute of Management Lucknow.
...
