02 Feb Earnings per share
One of the first financial ratios learnt by financial or investment students is that of earnings per share (EPS). It’s a quick and easy ratio which in theory enables investors and others to compare company performance not simply across a sector but also across multiple sectors.
Of course, theory and practice don’t always go hand in hand. For example, what in one sector may be a strong EPS result may be totally unacceptable in another. And when looking at EPS, it is wise not to take a single figure in isolation. Trend analysis will show far more about a company’s performance than a single figure could ever do. We should also consider that EPS is a prime component of other indicators such as price/ earnings or price-earnings to growth ratios so any mis-statement of EPS can have knock on effects on other indicators.
With that in mind, let us look at how EPS is calculated. The simple formula looks to divide net profits by the number of shares. However, nothing in life or shares is completely simple; so, if there are outstanding preference share dividends they have to be subtracted from profits before the calculation is made. Oh yes, and if the number of common shares has changed over the period, then a weighted average needs to be used.
Even then, you cannot be sure that you are comparing like with like as a thematic review by the Financial Reporting Council has shown. That review revealed that there are a number of areas which need to be improved before EPS can be seen as a reliable indicator.
Prime amongst these areas is that calculation of the weighted average of shares in circulation. The International Accounting Standard which covers the calculation of earnings per share (IAS 33) does not require specific disclosures on the calculation of weighted average. Nevertheless, the FRC review found that in a number of cases the information provided was insufficient to enable a meaningful interpretation of the indicator. It also found that: “Certain requirements of IAS 33 appear to have been overlooked or not well understood by companies.”
Their findings have led the FRC to make a number of recommendations in respect of methods of calculation and disclosure. These include ensuring that calculations following share reorganisations, reverse acquisitions or when preference shares are classified as equity are clearly set out with methodologies following IFRS and IAS standards.
EPS can be a valuable tool for investors, lenders, and companies. Clearly setting out the basis for its calculation can help to promote dialogue and to build understanding.