The following summary was written by Frank Voisin, who regularly writes for Frankly Speaking. Recently, Frank sold four restaurants and returned to school to complete a combined LLB/MBA.
Two key points on EPS:
1. Don’t attribute a lot of weight to a single year’s EPS
2. If you must use short-term earnings, look for things that are artificially inflating EPS.
With regard to #2, this is an important aspect of reviewing a company’s financials. Basic EPS is one thing, but it is crucially important to look at the Diluted EPS, which takes into account any convertible securities that would diminish the EPS if it was profitable to the convertible security holders to do so.
Additionally, you want to hunt through the footnotes to the financial statements to find special charges that should be considered in or removed from the EPS. In determining how to deal with the special charges, you should consider how they arose - are they truly extraordinary or can you expect similar charges to occur in the future? If you expect them, or similar charges, to occur in the future, then be sure to remove them from earnings when calculating Fully Diluted EPS.
Beware Big Baths. Big Baths are when companies, knowing that the market already has low expectations (due to a bear market) for performance amongst companies in the industry, take special charge-offs for future losses, which then creates higher figures in the next few years when the expenses are actually incurred. Be careful, because this has the effect of skewing the way a company’s performance looks as compared to reality. This is another reason it is helpful to look at average EPS over many years.
Taxes: Also pay attention to taxes - if the company has taken special charges that you do not feel are recurring, and so you remove them from the EPS figures, you must also adjust the earnings to remove the tax write-off of the special charge (which has been removed).
Accounting Policy Changes: Look for any changes in the accounting policies that would have an effect on the way earnings are reported so as to artificially increase earnings as compared to previous years without actually changing anything. Depreciation policies are a good place to start (switching from accelerated to straight-line will inflate EPS), as are R&D policies (Switching from expensing to amortizing begs the question - Why switch?).