Most investors rely on Earnings Per Share (EPS) as a measure of the performance of a company. In theory it’s a simple calculation based on post-tax earnings divided by the number of ordinary shares in issue as defined by the IAS 33 accounting standard (see link below).
But the number of shares can be affected by the future exercise of options, convertibles and warrants so in addition to the “basic” figure a “diluted EPS” figure is also required to be published. The EPS figure is also calculated not on the simple number at the end of a period but on the average over the time period to reflect the fact that earnings accrue over the period. This can create complications when there has been restructuring of a company involving share issuance or consolidation.
Another point to note is that only profits or losses from “continuing operations” are included in the basic EPS figure so as to reflect the fact that only those operations will be generating profits in future.
The Financial Reporting Council (FRC) has recently undertaken a thematic review of EPS to identify any possible issues in how EPS is calculated and reported – see link below.
They have identified some problems in practice and say “Certain requirements of IAS 33 appear to have been overlooked or not well understood by companies” and they are concerned that as judgements are sometimes used on share reorganisations the lack of disclosure on how EPS has been calculated is of concern.
EPS can also be used as a performance measure in bonus or LTIP calculations but it seems that sometimes EPS is calculated in a different way for that purpose. The FRC suggests any difference needs to be explained.
They also discuss the problem of “adjusted” EPS which are commonly reported. The FRC expects these to be reported in accordance with the ESMA Guidelines on Alternative Performance Measures – see link below. But what adjustments are included and how tax is taken into account can often be unclear. What is a reasonable adjustment is also often a subject of management opinion and this is surely an area where tougher standards could be introduced.
Companies where adjusted earnings are wildly different to basic figures should be viewed with suspicion in my opinion and a close examination of the adjustments is worthwhile in those cases (usually given in the Notes to the accounts).
The FRC Review is worth reading to get some understanding of the issues but a detailed study may be of more interest to accountants and auditors.
In summary, EPS can be a useful measure but it is only one measure of the performance of a company. It should not be relied on alone to judge the quality of a business and it is necessary to have some understanding of how it has been calculated.
Roger Lawson (Twitter: https://twitter.com/RogerWLawson )
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