Many varieties of EPS are in use today and investors need to understand what each represents if they are to make informed investment decisions. For example, the EPS announced by a company may differ significantly from what is reported in the financial statements and in the headlines. As a result, a stock can appear over or undervalued depending on which EPS is used. This article will define some of the varieties of EPS and discuss their pros and cons.
By definition, EPS is net income divided by the number of shares outstanding, however, both the numerator and denominator can change depending on how "earnings" and "shares outstanding" are defined. There are numerous ways to define earnings, so let's start with shares outstanding.
Shares outstanding can be classified as primary or basic (primary EPS) or fully diluted (diluted EPS). Primary EPS is calculated using the number of shares that have been issued and held by investors. These are the shares that are currently on the market and can be traded.
Diluted EPS involves a complex calculation that determines how many shares would be outstanding if all warrants, options, etc. executables were converted into shares at a given time, usually at the end of a quarter. Diluted EPS is preferred because it is a more conservative number that calculates EPS, as if all possible shares were issued and outstanding. The number of diluted shares can change as stock prices fluctuate (as options move in or out of the money), but Street generally assumes the number is fixed as indicated by 10-Q or 10-K.
Companies report primary and diluted EPS and typically focus on diluted EPS, but investors should not assume this is always the case. Sometimes diluted and primary EPS are the same because the company does not have "in-the-money" options, warrants, or convertible bonds outstanding. Companies can discuss any of them, so investors need to be sure which one is being used. (For more information, see Getting the Real Profits.)
As a general rule, EPS(earning per share) can be whatever the company wants it to be, depending on assumptions and accounting policies. Corporate spin-docs focus media attention on the number the company wants in the news, which may or may not be the EPS reported in documents filed with the Securities & Exchange Commission (SEC). Based on a set of assumptions, a company can report a high EPS, which lowers the P/E multiple and makes the stock look undervalued. The EPS reported in 10-Q, however, can result in a much higher EPS. low and an overvalued stock in P/E. That's why it's critical that investors read carefully and know what kind of earnings are used in the EPS calculation.
There are five types of EPS
Reported EPS (or GAAP EPS)
We define reported EPS as the number derived from generally accepted accounting principles (GAAP), which are reported in SEC filings. The company earns this income in accordance with the accounting guidelines used. A company's reported earnings can be distorted by GAAP. For example, a one-time gain from the sale of machinery or a subsidiary could be treated as operating income under GAAP and cause a spike in EPS. Additionally, a business might classify a large sum of normal operating expenses as an "unusual charge," which can increase EPS because the "unusual charge" is excluded from the calculations. Investors should read the footnotes to decide which factors should be included in "normal" earnings and make adjustments to their own calculations. (To learn more about what can be found in footnotes, read Footnotes: Start reading the fine print.
EPS in progress
Ongoing EPS is calculated based on normalized or ongoing net income excluding anything that is a one-time unusual event. The goal is to find the earnings stream from core operations, which can be used to forecast future EPS. This may mean excluding a large one-time gain from equipment sales, as well as an unusual expense. Attempts to determine an EPS using this methodology are also called "pro forma" EPS.
EPS Pro Forma
The words "pro forma" indicate that assumptions were used in deriving any number in dispute. Unlike reported EPS, pro forma EPS generally excludes some income or expense that was used to calculate reported earnings. For example, if a company sells a large division, it could, when reporting historical results, exclude income and expenses associated with that unit. This allows for more of an "apples to apples" comparison.
Another pro forma example is a company that chooses to exclude some expenses because management believes that the expenses are non-recurring and distort the "true" income of the company. However, non-recurring expenses seem to appear with increasing regularity. This raises questions about whether management knows what it's doing, or is trying to create a "rainy day fund" to smooth out EPS.
The EPS title is the EPS number that is highlighted in the company's press release and picked up in the media. Sometimes it is the proforma number, but it could also be an EPS number that has been calculated by the analyst or expert discussing the company. Generally, sound bites do not provide enough information to determine which EPS number is being used. (To learn more about how companies can skew their results, read 5 Tricks Companies Use During Earnings Season.)
Cash EPS is operating cash flow (not EBITDA) divided by diluted shares outstanding. In general, effective EPS is more important than other EPS numbers, because it is a "purer" number. Effective EPS is better because operating cash flow cannot be manipulated as easily as net income and represents actual cash earned, calculated by including changes in key asset categories such as accounts receivable and inventory. For example, a company with a reported EPS of 50 cents and cash EPS of $1 is preferable to a company with a reported EPS of $1 and an effective EPS of 50 cents. Although there are many factors to consider when evaluating these two hypothetical stocks, the company with cash is generally in better financial shape.
Other EPS numbers have dwarfed effective EPS, but we expect it to get more attention due to the new GAAP rule (FAS 142), which allows companies to stop amortizing goodwill. Companies may start talking about "cash EPS" to differentiate between pre-FAS 142 and post-FAS 142 results, however, this version of "cash EPS" is more like EBITDA per share and does not account for changes in accounts receivable and inventory. Consequently, it may not be as good as Operating Cash Flow EPS, but it is better in certain cases than other forms of EPS.