EPS has deep of roots in the financial literature. EPS is perhaps the first metric to be used for valuation in relationship to stock price returns by Ball and Brown (1968). The relationship was further confirmed by many using the improved empirical models. Ohlson (1995) has empirically has proven the positive correlation between the EPS, dividend yield and book value in stock valuation. Adding to that Collins (1999) studied the relationship between equity of highly leveraged firms (negative equity) and stock valuation. Collins and Kothari (1989) used inter temporal cross-sectional data to demonstrate the effect on stock prices in response to change in EPS. Relationship between firm size, change in earnings and the stock returns has also been studied by Collins and Kothari (1989).
In addition Graves et al. (2010) has seconded the notion of analyst's forecasts being better predictors of future financial returns when compared to mechanical time series models. Murphy (1966) has also empirically proved the correlation between the earnings growth of the past to that of the future in successive periods.
Misleading??
EPS is required to be disclosed by the IAS 33 (IASB 2008a) and perhaps is the most widely quoted ratio of all. As a result of this a lot of companies report "adjusted earnings" in their press releases. These non-statutory earnings may be referred to as "pro-forma", "normalized", "core" etc. as they are produced by non-adherence of the standard accounting principles and are then utilized to produce the EPS. It is because of this that these figures are heavily criticized by the securities and exchange commission (SEC)(U.S) and by various other associations representing investors (Lougee & Marquardt 2004). Johnson & Schwartz (2005, p919) have also gone to the extent of calling EPS as EEBS (Earnings Excluding all the Bad Stuff)
EPS and Share Count
There is no specific standard for the ideal number of shares that a company should have. Some companies prefer a lesser count of shares while other more. In such conditions even if the companies have a similar amount of capitalization the EPS may vary highly between the two.
Microsoft Corporation (NASDAQ:MSFT) have 8,381.0 M, 8,376.0 M, 8,668.0 M & 8,908.0 M & 9,151.0 M outstanding shares in the past five years. While Apple Inc. (NASDAQ:AAPL) has 937.27 M, 934.98 M, 932.21 M, 929.28 M & 926.9 M shares outstanding in the past five years and going from the table given below clearly AAPL's EPS have been many times higher than that of MSFT's. Value investors going by this metric could very well be deceived away from MSFT.
MSFT Historical EPS
AAPL Historical EPS
EPS and Debt
An EPS metric of the firm tells the investor nothing about the debt structure of the firm. Consider two companies having the same amount of outstanding shares and a similar income. The only difference is that Company A is o% leveraged and Company B is 60% leveraged. For investors going by this metric both the companies will look similar with their almost similar EPSs. The problem is even worst when company A has greater revenues, in this situation an investor would definitely rule in favor of company A unaware of its leverage.
EPS and buybacks
Buybacks increase the EPS instantly. Infact most of the companies resort to buybacks to improve their metrics to generate investor's interest. And the value investors somehow negate the fact that the inflated EPS cannot be converted into cash.
Exxon-Mobile (NYSE:XOM) is known for its regular buyback programs. The period between 2002-06 alone saw the company's outstanding shares go down from 6.809 billion in the beginning of 2002 to 5.73 billion at the end of 2006, With the amount being spent on the buyback in 2006 alone standing at $29.6 billion.
In this analysis I will compare the scenario where no such stock repurchases had been done between the periods 2002-06 and then compare the EPS under such scenario to the actual EPS that the buybacks resulted in.
2002
2003
2004
2005
2006
Shares outstanding, beginning of year
6,809
6,700
6,568
6,401
6,133
Amount spent on repurchase
4,800
5,900
10,000
18,200
29,600
Shares repurchased
127
163
218
311
451
Shares outstanding, end of year
6,700
6,568
6,401
6,133
5,729
Shares for compensation plans
18
13
51
43
47
End of year earnings7
11,011
20,960
25,330
36,130
39,500
Weighted average number of shares
6,780
6,634
6,482
6,270
5,913
Earnings per share (EPS)
1.62
3.16
3.91
5.76
6.68
Total dividends paid
6,200
6,500
6,900
7,200
7,600
Dividends per share (DPS)
0.92
0.98
1.06
1.14
1.28
Average 3-month treasury bill rate
1.12
1.02
1.55
3.14
4.53
Scenario without Repurchase
2002
2003
2004
2005
2006
Additional cash, end of year
4,800
10,716
20,764
39,110
69,274
Additional earnings from cash during year
27
79
244
940
2,458
Tax on additional earnings
11
32
98
376
983
Additional earnings net of taxes
16
48
146
564
1,475
# of shares outstanding if no repurchase
6,827
6,858
6,909
6,952
6,999
EPS if no repurchase
1.62
3.06
3.69
5.28
5.85
Tax savings per share from repurchase
0
0
0.02
0.06
0.17
As evident from the tables above it can be seen that with repurchases taken off the account the no of outstanding shares by the end of 2006 would have been 6,999 on the balance sheets. This is quiet substantial when the actual amount that is left was 5,729, but the amount of shares used by XOM was the weighted average (5,913 shares). By taking off this effect in the calculations it is seen that the reported EPS of $6.68 is quiet high when compared to the one calculated without the buyback i.e. $5.85. The increase in EPS is due to three reasons.
Buyback reduced the outstanding shares in the EPS calculation.
Buyback led to smaller amount of cash on hand, which in turn leads to lesser earnings due to lower interest on the cash on hand.
Buyback led to reduced earnings which in turn led to reduced tax on earnings which for XOM stood at 40%.
Thus calculating the artificial growth in the EPS of XOM over the years 2002-06
5.85-1.62 = 4.23
6.68-1.62 = 5.06
1 - (4.23/5.06) = 0.16404
=16.404% increase in EPS
This 16.404% increase over the period can be attributed to the financial engineering rather than the growth in their revenues.
It is this financial engineering that misleads the value investors by the increased EPS and this resulted in the XOM stock from $40 in 2002 to $80 in 2006.
The misleading growth of EPS
The growth portrayed by the EPS can be seriously misleading to shareholders.
AAPL's growth is the last decade has been a fairy tale. On closer examination of the last 9 years (2002-2011) annual EPS.
AAPL Earnings Per Share TTM
Calculating CAGR
Solving for x
0.09(1+x)10 = 42.55
X=85.13% (approx.)
This means the AAPL has registered a Y-o-Y growth 85.13% on EPS. I then compounded the growth rate for the next 10 years with the CAGR of 85.13%. This resulted in an eye popping EPS of $20,121.83 in year 2021. Now assuming the no. of outstanding shares in 2012 remains constant over this period (the no. of outstanding shares has been constantly increasing for the past five years). I then multiplied the no. of outstanding shares with the calculated EPS to get the annual revenue of the firm in 2021.
No. of outstanding shares in 2012: 937,270,000
Projected EPS in 2021: $20,121.83
Annual Income in 2021: 937,270,000 x $20,121.83 = $1,885,958,760,410
Annual revenue of $1.885 trillion. This alone is 3.77% of the total market cap of all the publically traded companies in the world reached on August 2008 ($50 trillion) (http://en.wikipedia.org/wiki/Market_capitalization)
EPS in the Cyber Boom of the 90s!!
The 90s witnessed a sudden boom in the cyber, services and silicon stocks which saw the stock market grow through the roof. This was seen by many as a beginning of a new era of virtual economy (Earning and dividend quality ranking) this was followed by a shift in investment and strategies. This decade saw the emergence of numerous hi tech companies which were looked upon to process vast growth prospects, ease of access to global markets, low input & supply costs etc. The financial analysts responded to this by abandoning age old valuation methods and creatively introducing new ones. One such analyst was Henry Blodged an analyst at Merryl Lynch, who brought in a new valuation method that suddenly saw a large potential in the Yahoo stocks after the company received large tax breaks which subsequently was followed by many Yahoo employees exercising their stock options {6}. The markets saw shift from measures to "growth indicators" such as customer base growth rate, p/s revenue ratio. All of a sudden the investors viewed that these new stocks processed the uninterrupted growth potential but failed to recognize the fact that these high prices of stocks did not correlated with similar increase in the company's earnings. Speculative activities and market sentiments led to the ignorance of fundamentals. And when the bubble burst it left behind several bankrupt companies and unemployed people. Misguided investors witnessed grave losses and came to realize the fact that the stock prices were not true reflector of the companies potential and this this resulted in boosted confidence in the fundaments of corporate finance for accessing a company's performance.
The increase in fraudulent earnings by management these investors started to question the accounting techniques employed and demanded increased transparence and are now more focused on the quality of earnings which is often referred to as a proxy of a long term scope of the company which emphasizes more on the sustainability as its top priority. A good measure of the quality of earnings could also indicate towards the changes in the company even before the changes actually occur.
Merryl Lynch identifies 6 ratios as indicators for the quality of earnings. ROCE, Cash Realisation, PARR, tax rate & debt rating. A study conducted by Patel and Santictva in 2003 shows that a portfolio composed of stocks that have high S&P equity scores gives highest risk adjusted returns even higher than the S&P 500's index. It was also found out that the firms with better earnings quality scores had even better earning predictability which in turn leads to better earnings forecast by analysts.
Quality of Earnings
Investors have relied on consensus EPS over the last decade, where a failure to meet these estimates could lead to its stock being decimated. This led to the attention of the managers towards these figures who then produced figures that were healthy but blurred earnings that masked the warning signs eg. Xerox, Enron, Parmalat etc. This situation warranted the analysts to define better indicators of the quality of earnings figure published to improve the situation.
The need for the study of the quality of earnings came from the fundamental analysis which was developed to spot the over and undervalued securities from their financial statements to get a better understanding of the firms operations. It rests on the fact that the market value of the firm is below/above the intrinsic value of the firm to deem the stock as over/under valued respectively. In the later part of the 20th century deep studies into the quality of the earnings started. O'Glove studied the quality of earning as determinant of the future prospect of the company in consideration and subsequently provided investment opinion based on the study. This also let to successful identification of the distressed companies as expected.
Bernstein and Siegel were the introducers of the quality of earnings in 1979 by carrying out a survey {3} that determined the factors that determined the quality of earnings by recording the opinion of several researchers and analysts. The most prominent issue addressed was the growth of earnings by the management's manipulation that contributed to misguiding figures and a substantial in the reduction of these as a proxy of future earnings.
There has been a substantial in the awareness in the quality of the earnings ever since. A study with fund managers as subjects conducted by Merryl Lynch's global strategy team in 2002 March concluded that the 43% of the subjects opinionated that the U.S equities had the best earnings qualities while 9% denied that. The figures detoriated with 34% of the subjects believing that the U.S equities had the worst quality of earnings. [9].
Formal Definition
The quality of earning being a relative measure and its broad scope do not have a defined measure yet. Following are the various definitions of the concept.
"On of comparative integrity reliability and predictability" is how Bernstein & Siegel define the quality of earnings. Similar that views expressed by the Securities Exchange Commission (SEC). Accounting Series Release (ASR) No.159 states. Who have explained this to enable the investors to explain the source and the probability of reoccurrence of net income, and thus of the earning's quality. "if the companies accounting principals are at variance with the prevailing accounting practices with in the industry, the dollar effect on earnings should be disclosed for there to be a proper assessment of the quality of registrant" Release No33-5427 Hence emphasizing the impact of different accounting schools and managerial manipulation in the quality of earnings Brown (4) emphasized that the financial analysts are critical of accounting earning for valuation purpose and that "the key is to separate economic value added from "cosmetic earnings",, "earnings quality may misleading for obvious reasons- reported earnings use large one shot revenue items that have no bearing on future earnings potential, for example substantial research and development write offs that artificially depress the current earnings. But a much more subtle factor particularly complicates the assessment. Management teams can always manage the level of trend of reported earnings" "larger return of total capital." Is how Merrill Lynch has defined good quality of earnings. But also states that the high quality earnings should not depend on transients, for example: reported tax rates should not bear addition of risk as a result of high financial leverage and dividend obligations."
In a nut shell all these definitions boil down to
Identification of the component of earnings that results in cash.
Use of consistent and accurate measures of no transactional elements such depreciation, provision of bad debts etc is of utmost importance
Transients have to be identified and rectified in line to portray future sustainability.
It is the fact that quiet a few elements such as the operational route of the company, full disclosure and management strategy cannot be clearly analyzed makes the determination of the quality of earnings difficult. Higher quality of earnings require a clear and precise measure of the above discussed elements and other elements such as adherence to GAAP etc.
Indicator measures
Altough difficult but Prof. David Hawkin from Harward Business School has suggested 6 accounting metrics that encompass the different aspects of good quality of earnings. Following are the metrics
C:\Users\Shahzad\Downloads\table-page-002.jpg
Comparison of different accounting methods and their impact on quality of earnings (Source: Deloitte & Touche)
ROCE
ROCE is the ability of the firm to generate income from its operations. This is excluding the income from the activities such as financing etc. ROCE is further divided into 2 parts namely operating profit margin and asset turnover via the Du Pont model, where the former is a profitability measure and the latter is the efficiency measure. There is a tendency to penalize the decrease of profit margin especially when there is a decrease in gross margin where the factor effecting the overall ratio are the intensity of the competition and the operating expenses . Hence a noticeable shift in the metric system (ROCE) more or less relates to the long term prospects of a company. A lower/poor ROCE indicates inefficient usage of funds and decreased profitability thus indicating poor earnings
FORMULA
Cash Realization
Cash Realization is a measure of the company's cash generation capability that gauges the proportion of cash inflow in the net income. This measure is touted to be quiet helpful when it comes to identification of managerial manipulations by the route of non-transactional income eg aggressive accounting techniques cash inflow reduced by increase in account receivables could indicate the firms strategy of boosting revenue by credit extension which in turn results in lower persistence of earnings metric. A CR figure of below 1 is generally accepted as an indicator of poor quality earnings.
FORMULA
PARR
During the times of recession and other slowdown the common tendency of firms is to act on conservative strategies usually by taking down the R&D cost/investments and boosting the earnings figure. Such an achieved figure is not a healthy one. Such a deduction in R&D projects to boost earnings could result in decline of the growth prospects of the company. Such a strategy is known to impact the tech companies heavily. In addition to this the adoption of such a strategy could also indicate that the firm has insufficient funds to maintain a certain level of investment in the capital assets. PARR is a measure of the sustainability of the firm's growth. Long term managerial strategies are reflected by high PARR and high quality of earnings are generally classified by a PARR of above 1
Formula
S&P 500's Debt Score
The long system of the debt score of the S&P takes into consideration the following factors:- independence, objectivity, integrity and disclosure. There is a thorough analysis of the industry, business principals and the growth prospects of the firm in the rating process. The given ratings are then refreshed frequently to reflect the change in the economic conditions and other changes/development in the business. This rating is looked at as a metric that describes the quality of earnings and works as a bridge for the gap between the different companies of the same sector thus facilating comparison.
