In the financial statements of companies, EPS is perhaps the first parameter company’s fundamentals that attracts an investor. Lot of investors take their buy-sell decision on basis of EPS alone. Believe me, the companies knows this and hence they often produce EPS to you in a manipulated way. In this article we will see how to identify any bungling in EPS so that our investment decisions are free from any wrong assumptions.
I would like to make a point before starting this discussion that by analyzing any companies EPS we are trying to understand the robustness of companies earnings over a period of time. Earnings of a company perhaps drives all future business decisions, so if earning is healthy the business will grow along with its stocks prices. So the degree of growth of earnings of companies over a period of time is of supreme importance for investors.
True EPS of companies
As I said earlier, EPS of companies are not always quoted properly by companies in their financial statements. Generally earnings are reported in the financial statements of companies by an accounting principle called as GAAP (Generally Accepted Accounting Principles). This accounting principle has its own advantages and disadvantages. The main problem that GAAP EPS has is ‘reported earnings and cash in hand’ are not same. Let me explain, suppose a company declares that it has made $10 million profit in year 2010, does it means that on 31-Mar’2010 it has $10 million in its bank as cash?
The answer is no, as per GAAP the companies are allowed to book earnings/ profits in their financial statements as soon as the sale transaction has been made. The payment terms may say that the sale can be made on 30 days credit, hence from the date of sale the money comes in hand (from customer) after 30 days. On paper though the companies are allowed to book profits/earnings but actually there is no cash in hand. This is the biggest fallacy of reported EPS’s. Investors shall also be (more) interested on the free cash generated by the company (after paying all its expenses) over a period of time.
Moreover the companies has more chance to manipulate its income statement (company’s sales figures, expense figures, taxes and duties paid) than the cash flow statement. It is general belief that the cash flow statement is more transparent and honest then other financial statements. Cash flow statement gives a picture of the company that speaks about companies potential to manage its cash-outflows. If a company is able of pay all its dues and still manage to retain some cash in their bank (say at the end of a financial year) that is the real profit. Cash flow statement of accounts this free cash is called as “Net (decrease)/increase In Cash and Cash Equivalents”. This is the real net earnings/ profit of the company.
How to scrutinize Earning Per Share (EPS)?
The best way to scrutinize EPS is by comparing the reported EPS (say for last 7-10 years) with the net operating cash flow of the company. Reported EPS’s can e obtained from profit and loss accounts and net operating cash flow can be obtained from cash flow statements. The idea of collecting these two details is to compare the two.
- If reported EPS is more than operating cash flow per share then it means company is making less cash then reported in EPS.
- If reported operating cash flow is negative. In this situation company will certainly require loans/debts to manage their cash flow. Even if companies report high earnings/profits if operating cash flow is negative it shall means nothing for investors.
- If reported EPS is less than operating cash flow per share then it means company is making more cash then reported in EPS. This is a quality EPS for investing purpose.
Example of high quality Earnings. Below figures are not per share values.
| Tata Steel | Net Profit after Tax ($.) | Net Operating Cash Flow | Net increase in cash/cash equivalents as compared to last year |
| Mar’11 | $6865.69 | $8542 | $0907.40 |
| Mar’10 | $5046.80 | $8369 | $1641.25 |
| Mar’09 | $5201.74 | $7397 | $1125.56 |
| Reliance Industries | Net Profit after Tax ($.) | Net Operating Cash Flow | Net increase in cash/cash equivalents as compared to last year |
| Mar’11 | $25242 | $33280 | $13672 |
| Mar’10 | $20547 | $20490 | $8713 |
| Mar’09 | $18433 | $18245 | $17894 |
Example of comparatively low quality Earnings. Below figures are not per share values.
| L&T | Net Profit after Tax $ | Net Operating Cash Flow | Net increase in cash/cash equivalents as compared to last year |
| Mar’11 | $5832 | $3861 | $298 |
| Mar’10 | $5880 | $5482 | $656 |
| Mar’09 | $3940 | $1478 | $189 |
Conclusion
It must be noted that it is equally important for companies to manage both earnings/profits and cash flows. Perhaps short cash management is so important that even though the company may be profitable on papers, but bad cash flow can taken them out of the market. Sometimes companies are in their expansion or modernization mode, in such times the net cash flow can be negative. Actually companies sacrifice their short term cash flow (by spending on projects, marketing etc) for long term growth. This is also great positive sign for investors.
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