A valuation metric that compares a company’s share price to its earnings per share (EPS). It indicates how much investors are willing to pay today for $1 of current or future earnings.

Earnings per Share (EPS)

Earnings per share show a company’s net income for a selected period on a per-share basis and are calculated as:

EPS = Net Income / Number of Shares Outstanding

Essentially, EPS is a metric that shows how many dollars of net income a company earned per share during the selected period.

There are two types of EPS: basic and diluted. Basic EPS is calculated using the current number of shares outstanding, while diluted EPS uses an increased number of shares outstanding. Diluted EPS assumes that all potential shares, such as employee stock options, have been exercised, which increases the total number of shares. We prefer diluted EPS because it is more conservative and better reflects a realistic perspective for shareholders.

Things to Watch Out For

Since the analyst community and Wall Street in general tend to focus on next-quarter EPS—forecasting EPS and then comparing it with actual results to determine whether there is a “surprise,” which in turn influences stock movements—some companies have an incentive to inflate EPS through various accounting and financing techniques. Below are some of the most common practices to watch for:

• Use of “adjusted” net income to calculate “adjusted” EPS.
  While the stated reasons may vary, the key point is that companies adjust their net income—most often upward of course—to produce a higher numerator and, consequently, a higher EPS.
• Excluding “one-off” or “restructuring” expenses.
  Investment history shows that few items appear in financial statements with as much regularity as those labelled “one-off.”
• Including proceeds from the divestment of assets in net income.
  This can produce a significant increase in EPS, even though such gains are non-recurring in nature.
• Capitalizing operating expenses to increase net income and EPS.
  One common example is IT development costs, which often require judgment to distinguish between operating expenses and capital expenditures. Be cautious when most or all IT (or similar) expenses are treated as CAPEX.
• Systematic use of aggressive leverage (debt) to finance share buybacks.
  This reduces the number of shares outstanding and can gradually increase EPS. In some cases, this strategy may work if (a) the cost of leverage is low, (b) overall leverage levels are not excessive, and (c) the intrinsic value of the stock is above its current market price. However, when applied regularly without discipline, this approach can lead to an overleveraged capital structure that is dangerous for long-term shareholders.

How to Deal With It

We prefer using diluted EPS calculated based on fully diluted net income in accordance with IFRS or GAAP. If there are significant year-over-year swings in EPS that cannot be reasonably attributed to operational performance, additional normalization may be required. This helps arrive at a more representative average EPS and EPS growth rate, which can then be used to assess financial performance or in valuation metrics such as the P/E ratio.

Some companies with a strong track record of steady EPS growth over time:

1. CTAS
2. COST
3. Visa
4. Mastercard

Some examples of companies using leverage to finance share buybacks and drive EPS growth: