Triston Martin
Aug 22, 2022
A firm's earnings per share statistics might be difficult to understand. More than that, there are several opportunities for management to influence EPS in their favor. If you want to know what sort of information an EPS is giving you and how you may safeguard yourself as a trader, this post will teach you how to assess the credibility of any EPS.
Before diving into an EPS quality analysis, it's helpful to have a firm grasp on what EPS really is. Earnings per share (EPS) is a calculation based on a firm's net revenue divided by the number of shares it has in circulation. There are normally four sections to an income statement. The direct expenses of a business and how they translate into net income and gross margin are examined first. Second, we'll analyze indirect expenses to determine operating income (sometimes called EBIT or "revenue before interest &'' taxes") and operating margin. Third, after deducting interest and taxes from EBIT, the firm's net income is calculated. Last but not least, a detailed examination of profits per share.
The earnings are broken up into two aspects in the last part of the income statement, which is about earnings per share. Earnings per share, both basic and diluted, are reported by publicly traded firms. Earnings per share (EPS) is a common measure of a company's performance that is calculated by dividing its net income by the number of its shares that are freely traded. To calculate diluted earnings per share, we divide net revenue by the sum of all outstanding shares (free float plus convertible shares). Commonly, businesses and the media emphasize diluted profits per share. Non-GAAP measurements are also used to revise the earnings per share (EPS) section of the income statement. Managing shares or making changes using non-GAAP items are two ways in which companies might possibly artificially inflate EPS.
Earnings per share (EPS) with a high-quality rating may be an accurate reflection of the company's underlying profitability. Very few modifications to results outside of GAAP are expected to be included. That company's profits recognition method may be at play as well. The methods used to account for revenue will differ from business to business. These tactics are simple to miss, yet they make a huge difference in determining EPS' overall quality. When a corporation is able to better control its costs and increase its margins, the resulting earnings per share (EPS) may be judged to be of a higher quality.
Poor quality EPS reporting may be indicated by factors such as increased costs, many non-GAAP adjustments, and needless changes to the number of shares outstanding. Management may adjust the number of outstanding shares by issuing or repurchasing shares. Revenue recognition is another area where accountants have some leeway. Yet, businesses cannot disclose EPS without acting ethically. Management issues and legal action, as in the instance of Enron and WorldCom, might result from ignoring revenue recognition requirements.
Given that EPS is derived from a company's profits, there are several methods through which to assess it. Evaluating the firm's costs and how they are controlled sometimes requires checking the income statement. All three margins—gross margin, operational margin, and net margin—are useful for assessing costs at various income statement stages.
When judging the quality of an EPS, it might also be useful to make comparisons. In and of itself, EPS is just the outcome of dividing a company's reported revenue minus costs by the number of shares outstanding. As a result, it is sometimes useful to examine EPS from a number of perspectives. Many investors break down earnings per share in the same way that margins are broken down so that they may examine total profit per share or earnings per share from ongoing business. It is also useful to examine industry-wide and company-specific EPS growth and comparisons. There should be reasons given for unusually strong growth or EPS growth compared to rivals. The cash flow statement, and operational cash flow, in particular, may provide investors with insight into earnings quality. Some investors compare operational cash flow to EPS. Cash from operations per share should be greater than earnings per share as a general rule for investors.
Overall, it might be a red indicator if a company's earnings per share (EPS) are rising, but there is no corresponding growth in operating cash flow or perhaps a decrease. Unrealized revenue receivables may lead to significant operating costs in particular situations. High depreciation or amortization costs over a lengthy period of time might be another cause. When operational cash flow is negative, it's important to look into things like debt, inventory turnover, and days' sales outstanding. The old adage goes something like, "cash is king," so it's understandable to be concerned if operational cash flow is sluggish even when profits increase consistently or more quickly than in previous years.
It was said before that investors should consider many measures of earnings per share. Therefore, patterns may play a significant role in the investigation. In certain cases, the growth of earnings per share (EPS) across an entire sector may be affected by the same set of macro factors that drive EPS growth in other industries. Additionally, a corporation may be ahead of or behind the market due to product innovations or higher than expected capital expenditures. In addition, companies may be disclosing lower-than-expected pro forma operational cash flow as compared to projected EPS. Earnings per share (EPS) analysis, EPS expansion in an industry, and operational cash flow may all be affected by a wide variety of external and internal variables. One bad or good quarter is possible for each firm, whether it's because of new planned investments or random chance.
It is possible to identify several situations with the use of trend analysis. Disparities and declines may have justifiable causes (financial cycles, the requirement to invest in future development), but they cannot persist indefinitely if the business is to succeed.
The quarterly earnings per share (EPS) report of any corporation is generally a hot topic. One of the most important indicators of a business's health on a yearly or quarterly basis is profits per share, which reveal the company's final profit or loss. Management and shareholders put a premium on it because of the interest it generates. From the standpoint of management, executives have a number of options at their disposal for attempting to influence earnings per share (EPS). Nevertheless, investors are also affected by this. Therefore it may be useful for them to get a firm grasp on what EPS stands for and how to assess it to ascertain the quality of profits.
Overall, markets have a reputation for efficiency. Consequently, market efficiency frequently results in lower values for firms with declining profits or low-quality earnings and higher valuations for those with expanding earnings. While there are methods that management may employ to manipulate EPS in their favor, traders and the market typically will not tolerate differences over extended periods of time. Consistently deteriorating earnings quality usually prompts activist involvement and/or shareholder litigation seeking retaliation for management's failure to prioritize shareholder interests when formulating EPS strategy.
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