as “look how much we could have earned if we didn’t have to pay our bills”. Interest on loans and tax are unavoidable costs of running a business and really should be taken account of. If the company sourced its capital from shareholders, instead of borrowing the money, then it would presumably have to pay dividends instead of loan interest. Tax is sadly unavoidable for us all, and does at least help provide a safe legal framework in which the company can operate. Depreciation and amortisation are even more basic expenses that have already been subtracted before the operating income is reported. As Warren Buffett asked: “Does management think the tooth fairy pays for capital expenditures?” I do not use EBIT or EBITDA further here.
Basic, diluted and adjusted EPS
Having calculated earnings with all necessary costs taken out, we can now move from the company level to the per-share level. EPS is calculated by dividing profit from continuing operations by the number of shares in issue. This is basic EPS.
However, the company may well have options grants outstanding to executives, and sometimes to employees too, which will vest if certain targets are attained. These give a higher number of possible shares in the future. Dividing profit by the number of all the shares that exist now or might possibly vest gives diluted EPS.
The figure often quoted in the financial press is adjusted EPS (also known as headline EPS). This uses earnings with exceptional items excluded – large, one-off costs such as the expense of closing down an unprofitable division. Unfortunately, the exact definition of what is classified as ‘exceptional’ varies by company – the company’s accountants have wide latitude over the accounting figures.
Historical, rolling and forecast EPS
Another possible dimension to the stated EPS figure is whether it is historical or forecast. Historical EPS is the simplest and is what has been covered above, i.e. the earnings stated in the company’s most recent annual report.
Rolling EPS is based on the latest available earnings information. In the UK, if the six-monthly interim report has come out, the earnings from the first half of the annual report drop out and are replaced by these most recent earnings. US companies, and many large companies that are quoted in the US such as BP, declare results quarterly, so for them the rolling figure is the most recent four quarters. These six-monthly or quarterly announcements are unaudited, so unlike the figures in the annual report they are subject to review.
Forecast EPS does not come from the company, although they may provide guidance. It is the average of the earnings expected to be declared for the current accounting period, as forecast by the analysts who cover the company. For a large company in the FTSE 100 this will mean a dozen or more analysts’ forecasts being available at any one time.
Since we are interested in the returns to be had from the company in the future, not the recent past, why do we not always use forecast EPS and forget about historic EPS? The major problem here is that forecast EPS will usually be quoted only if three or more analysts follow the company. Forecast earnings are thus available only for the few hundred largest UK companies – effectively, members of the FTSE-350 Index plus a few others. Of the roughly 1,300 trading companies quoted in London, there are hundreds with a market capitalisation of less than £50m. These are unlikely to have even three analysts covering them, particularly if they are quoted on AIM. Such companies have no forecast earnings and thus no prospective P/E figure.
Because of this limited coverage offered by forecast earnings, academic research to back-test particular trading rules invariably uses historical EPS, not forecast EPS. (The fact that you have to pay for a higher DataStream subscription level to get the analysts’ forecasts, and few universities can afford to do so, may also be relevant!)
Problems with earnings figures
There is a significant problem near the top of the profit and loss account. Operating income, being one large number (sales) minus another large number (costs), may be highly variable. Depending on the industry and business model, perfectly healthy companies may nevertheless have wafer-thin profit margins.
For example, Inchcape import and distribute thousands of cars every year. Given the huge volume of metal moving through their distribution channels, a 1% or 2% profit margin is very healthy. However a small percentage change in either sales or costs leads to a very large change in the operating income. Forecasting earnings figures for such companies is therefore a particularly error-prone business. Forecast earnings depend acutely on the assumptions made about how gross sales and total costs will change in the future.
Another sticking point when calculating earnings is that sales in any one year, and hence earnings, are easily manipulated. It was mentioned above that what is classified as an exceptional cost, and thus to be excluded from adjusted EPS, is a matter of opinion. The company’s managers are likely to take a more liberal view of what costs are exceptional than a potential investor. Some large companies seem to need to close down an unprofitable division or operations in some particular county every year, but they still book it as exceptional. When this seems to happen year after year, one is entitled to ask how exceptional it really is.
A whole branch of academic finance literature exists on the manipulation of earnings and how it may be identified. The dividing line between current managers wanting to present their actions in as positive a light as possible, and fraud, is not necessarily easy to draw. Any investor who follows the market for any length of time will have read about scandals of companies booking sales before they are absolutely definite, so as to enhance the apparent performance of the sales managers responsible and thus their bonuses. A recent well-publicised case is Findel, who run Kleeneze among other businesses. In 2010 their educational supplies division was found to have been making “unsubstantiated accounting entries”. Earnings had to be restated, the shares of the Group fell precipitately and have not yet recovered.
One final problem is the practical indeterminacy of EPS figures. Trying to pin down the precise basis of any particular basic, diluted, adjusted, forecast, rolling or historical EPS figure offered you is a real can of worms. Three different financial data sources, such as DataStream, the Financial Times and Hemmington Scott’s Company REFS will likely provide three different figures for EPS. However closely you read the online help files, unless you work as one of their data analysts and are able to read the computer code you will probably never know what exactly they include and exclude in their EPS figure. Even when I have sat down with a copy of an annual report and tried to work out exactly where an EPS figure came from, I have usually been unsuccessful. However, as long as you are using the same definition for all the companies you are considering investing in, it is unlikely to be a decisive factor.
Chapter 3. The Price-Earnings Ratio (P/E)
Having covered earnings in considerable detail, we are finally able to use the earnings figure arrived at as one of the two inputs into the P/E calculation.
The other input is of course the share price. At the level of detail required for the P/E, the price is quickly dealt with. The figure used in the quoted P/E statistics is invariably the previous day’s closing price, so unlike the EPS figure it will not vary from source to source. However, as with EPS figures there is still a certain amount of indeterminacy involved: bid, mid, offer and closing prices may all be slightly different and the method of calculation varies depending on the trading platform. The closing price may not necessarily be the price at which any shares actually changed hands. If you try to buy some shares today, the price asked by the market, and hence the P/E available, will have moved on again.
Understanding
