Different types of EPS and how to put them in perspective

By Kunal Jaggi

Keeping track of quarterly Earnings Per Share figures and the percentage changes, along with P/E ratio (multiple) is often the bread and butter of stock evaluation. It is important to know the different types of EPS that companies report and how to put them in the correct context. By definition, EPS is net income divided by the number of shares outstanding. However, both the numerator and denominator can change depending on how you define "earnings" and "shares outstanding".

1. Primary EPS is calculated using the number of shares that have been issued and held by investors. These are the shares that are currently in the market and can be traded.

2. Calculation of the Diluted EPS accounts for the shares that are currently in the market plus the extra shares that would enter the market is all exercisable warrants, options were converted into shares, hence diluting the ownership of current shareholders.

3. Reported EPS or GAAP EPS, which are derived using the Generally Accepted Accounting Principles. This value can be distorted if corporate management wants to make the EPS look high. For instance, a one-time gain from the sale of machinery or a subsidiary could be considered as operating income under GAAP and cause EPS to spike. Alternatively, a company could classify a large lump of normal operating expenses as an "unusual charge" which can boost EPS because the "unusual charge" is excluded from calculations. In both these scenarios, the EPS value is being artificially boosted by non-recurring benefits, just to make the stock look particularly attractive this quarter (or year).

4. Ongoing / Pro-Forma EPS
Calculated by using the normalized income, i.e finding the earnings stream from core operations that are recurring and excluding unusual, potentially one-time income / expenses. For example, while evaluating Apple the investor should focus on income from the core operations, i.e their products and services. If Apple had an additional $600 Million income through a litigation in their favor, it should not be considered as recurring income. Similarly, the investor should be cautious of companies dismissing some expenses as "one time" or "unusual"

5. Headline EPS
The EPS number that is highlighted in the company's press release and picked up in the media. Sometimes it is the pro forma number, but it could also be an EPS number that has been calculated by the analyst/pundit that is discussing the company. Generally, soundbites do not provide enough information to determine which EPS number is being used and often times it is simply the highest one that is stated publicly.

Caveats / Points to Remember

• It is good practice to use Diluted and Normalized (Ongoing / Pro-Forma EPS) figures in your valuation. You could even calculate Net Operating Income per share, or EBITDA per share and compare with previous years / quarters. Always use diluted though, warrants and options will be converted by owners if it is profitable to do so.
• Beware of "Tax benefits due to employee stock options" and other such non-recurring tax deductions. A way around this is to calculate Net Income Before Tax per share.
• You should always compare earnings growth relative to previous years / quarters. Steady increases in earnings per share is a good indicator of genuine growth and reduces the possibility that the company just had one great quarter which might not be sustained in the future.
• According to Ben Graham, you should read the company's financial reports backwards since they will usually hide what they dont want you to see in the end. This also means that you cant always take the exact figures from Google or Yahoo Finance, because those don't exclude income/benefits that are potentially one time.
• READ THE FOOTNOTES IN THE FINANCIAL STATEMENTS !!

The Intelligent Investor by Benjamin Graham (Warren Buffet's mentor) has some good warning signals

• In today's corporate climate, investors need to be especially beware of dilutive effect of issuing millions of stock options for executive compensation and then buying back millions of shares to keep those options from reducing the value of the common stock.
• Unrealistic assumptions of return on the company's pension funds, which can artifically inflate earnings in good years and depress them in bad.
• "Special Purpose Entities" - affiliated firms or partnerships that buy risky assets or liabilities of the company and thus "remove" those financial risks from the company's balance sheet. If a company is selling off their risky assets / liabilities year after year, it is not a good sign.