As earnings season continues, investors are keeping a watchful eye on their favourite companies' quarterly reports. Stocks become highly volatile during this period, moving several percentage points up or down based on a company's reported earnings per share (EPS) numbers. But too many investors blindly incorporate earnings per share (EPS) as a primary component of their valuations. EPS gets multiplied by a P/E multiple, or it is used as a base for growth rate multipliers to be discounted back to present value. However, for several reasons, investors must avoid using such short cuts in company valuations.
First of all, EPS can fluctuate wildly from year to year. Writedowns, abnormal business conditions, asset sale gains/losses and other unusual factors find their way into EPS quite often. Investors are urged to average EPS over a business cycle, as stressed in Security Analysis Chapter 37, in order to get a true picture of a company's earnings power.
EPS, averaged or otherwise, still does not provide adaquate information regarding a company's debt levels. Two companies could have the same EPS, but one could be capitalized with 99% debt while the other could have 0% debt. While the earnings to the shareholder is the same in both cases, one company is extremely risky and susceptible to bankruptcy should anything unexpected occur. To factor in debt levels, investors are encouraged to value a company based on its operating earnings (instead of its EPS) and subtract debt obligations from this value, and compare debt/equity values.
Finally, EPS does not give adaquate information regarding dilutive securities that have not yet been converted into common shares. "Diluted EPS" is a required reporting component of an income statement, but it only incorporates those options that are above water. For example, if a company has 100,000 shares that have averaged trading at $2.00/share, and 500,000 options outstanding at an exercise price of $2.01/share, not a single one of these options will be recognized in the diluted EPS calculation, despite the fact that these securities are potentially extremely dilutive! To avoid this trap, investors must subtract the value of options outstanding from the arrived at intrinsic value of the company.
EPS is a quick and easy way to refer to a company's earnings. It does not, however, serve as a replacement for prudent analysis of a company's true earnings power and obligations.