The Game of EPS

Anowar Parves ACCA

In October, 2018 the share of a listed company operating in textile sector was sold for Tk 4498, where the Face Value of the share is Tk 10 only. The price drastically floored to Tk 750 on November. Being smelled something unusual, the Bangladesh Securities and Exchange Commission(BSEC) called for reason to the exorbitant price hike. The Earning Per Share (EPS) for 3rd Quarter was declared Tk 12.18 and at the year-end it was finalized as Tk 36.16. For many years EPS is misguiding the investors through a variety of ways. 

Another footwear company announced its EPS as Tk 2.01 for year-end where it was Tk 1.11 on previous year. During one and half month the price of that share increased from Tk 75 to Tk 272, an excessive increase of 262%. In last four years the company reported EPS around Tk 0.50. The share price of a jute company was Tk 785 in December 2018 after an increase of 170% within one month. One of the reason behind the game was EPS according to some news. I can include another instance of EPS fabrication in Dhaka Stock Exchange(DSE). A textile company reported its consolidated EPS for the year as Tk 1.06 but they didn’t declare any dividend and eventually the shares were listed as ‘Z’ category. 

EPS Calculation

The earnings per share ratio is often a good performance measurement tool of how a company is meeting its objectives over time. It is widely used by investors in the stock market. However, companies know that the EPS is often a measure of how they are handling their businesses. This acts as an incentive for several CEO or managements of companies to manipulate the EPS ratio. The ratio is influenced if the company were to sell its shares of sponsor directors in the market. The net income or earnings can also be manipulated through the recognition of unearned revenue as well as deferring expenses and not maintaining adequate provisions. Both Earnings and Earnings per Share are major values of performances that can be manipulated or affected. It is particularly done by changing in the number of shares, weighted average of shares, earnings, expenses, provisions etc.

Earnings per share is a ratio and it is equivalent to the income of the company after it has paid all interest on loans it may have, taxes, and any dividends on preferred stock, divided by the number of shares outstanding. According to IAS 33 earnings per share must be published with the company’s financial statement. The calculation of EPS formula is given below. 

Scope of EPS manipulation 

The companies are manipulating EPS information in a number of ways. Some of them are uninteresting like wrong summation of figures. Most of the time the executives of companies intentionally fabricate EPS data and they sometimes disclose the price sensitive EPS information for insider trading.

The most common influence over EPS is changing the number of shares of the company. As you can see weighted average number of shares is in the denominator of the formula, a decrease in it will increase EPS. An electrode company in engineering sector has given false and different information of EPS in different pages of its prospectus(www.banglanews24.com). Another popular way of increasing EPS is inflating the earnings figure. It is done through not maintaining provisions of taxation, provision for loan losses, impairment losses etc.  A listed IT solution provider company didn’t comply International Accounting Standard(IAS) related to impairment losses. The company also inflated its profit in connection with not maintaining worker’s participation fund(www.banglanews24.com). A sponsor director of a steel manufacturing company sold his 26 lac share in May 2016. Just before selling his share the company announced a lucrative EPS for the year. Later it is discovered that the EPS was calculated without obligatory adjustments to the financial statement for income tax(www.arthosuchak.com). Calculation of dilution of EPS is another area of misrepresentation. Often dilution in earnings of listed companies are not shown as required by IAS. Interestingly companies not only inflate the EPS, they sometimes shrinkage the EPS in order to make better impression in future.

Why EPS may not please the investors

EPS is not free from errors and manipulation. Despite one of the major performance evaluation tool it has some serious drawbacks. One of the major drawbacks with EPS measure is that an organization has a lot of choice in determining the profit amount and it may be an item to manipulation. Therefore, it is important for an investor to be acquaint with adjustments to the operating profit. The earnings should be adjusted to
remove a wide-ranging nonrecurring, non-operating, and noncash items. The EPS should not be used as an only measure of company’s performance. Because the Management of the company have the information that investors heavily depends on using EPS as a performance measurement tool, they logically want to enlarge the EPS at every quarter and also at the year end. They often make decisions that increase the EPS in the short term, which may be at the cost of organization’s prospects in the long term. EPS can be altered by changing company’s accounting policy such as depreciation policy. It is therefore harder for investor to compare the results. Another serious shortcoming of EPS is that it does not consider inflation, the purchasing power of money is decreasing and this may be a catalyst for better EPS. The theory of economics suggests that the earnings of the company in Tk may be misleading as the value is not inflation adjusted. Where the company has a trivial EPS, the growth of EPS may not truly reflect the investors expectation over period. The investors always prefer to lookout the effects of gearing ratio in the investment decision. Unfortunately, the EPS doesn’t take into consideration of company’s debt position and financial leverage. Another drawback of EPS is that cash flow is not considered in it. The company may have good EPS despite it is struggling to pay bills. Moreover, EPS may not be comparable in case of company merger and acquisitions.

The standard of EPS

When the earnings of the company are accurately represented in the EPS, we call that a high standard EPS. In broad sense earnings can be cash or non-cash. Investors should always prefer cash earnings and the earnings must be included in the EPS. Cash earnings may differ from reported earnings in many ways. Net income can be distorted by not providing adequate depreciation. The accounting policies have impacts on net income and EPS. The investors may not have time and knowledge to evaluate the accounting policies of a company. As a result, while evaluating EPS of different companies through a lot of the financial tactics, the risk of misrepresented financial statements cannot be eliminated totally. The researcher argues that, it is harder to manipulate the statement of cash flows for a company. 

Alternative Measures of EPS

EPS is the basic performance measurement tool that is being used for many years. Despite its usefulness and easy to calculate, sometimes investors are not pleased with the result it produced. For investors, DSE has introduced Net Operating Cash Flow Per Share(NOCFPS) to be included in the financial statements. It is the net operating cash flow divided by the total number of shares.  NOCFPS can be a good alternative to the EPS, where cash flow is the matter of consideration and researchers believe that cash flow cannot be altered to a great extent as compared to net income. Investors can compare quarterly EPS to quarterly NOCFPS. Where NOCFPS is almost equal to EPS, it can be assumed that the reported income is trustworthy. Moreover, the investors can compare NOCFPS over time to get the trend and compare it with previous year. Al these results should also be compared with industry data. However, NOCFPS can be lower for some other reason like marketing expenditure or research and training cost. 

Other alternatives to the EPS can be Price earnings ratio (P/E ratio), Dividend Payout ratio, Dividend Yield ratio, Book Value per share etc. The P/E ratio is calculated as dividing market price per share by the EPS. It is used to evaluate if a stock is over- or underpriced. A relatively low P/E ratio could indicate that the company is underpriced. Conversely, investors expect high growth rate from companies with high P/E ratio. The dividend payout ratio is found by dividing the dividend per share with EPS. It determines the portion of net income that is distributed to owners. Not all income is distributed since a significant portion is retained for the next year's operations. Book value per share can also be a good measure to evaluate.  It can be found by shareholder’s equity with number of ordinary share. It indicates the value of stock based on historical cost. The value of common shareholders' equity in the books of the company is divided by the average common shares outstanding.

Finally, EPS is calculated based on historical figure and therefore doesn’t assure the investor that the performance of the company will be better for future. Investors decision must not be solely on EPS or its growth. Investors looking for alternative to EPS may consider cash earnings. There is no doubt that cash is one of the most important things to be considered by an investor and companies that generate a rising stream of operating cash flow per share are superior investments than other companies. Analysts suggest that investors can compare NOCFPS with EPS. A good NOCFPS can boost up the confidence of investors on the EPS calculated. 

written by
Anowar Parves ACCA
Member:
The Association of Chartered Certified Accountants &
Senior Principal Officer
Janata Bank Limited