Can you trust reported earnings figures?

Earnings per share (EPS) is perhaps the most widely quoted number from a set of company results. Many investors rely on it to give a snapshot of profitability and therefore the success, or otherwise, of the board of directors. But it can also be pretty misleading, according to fund manager and author of Accounting for Growth, Terry Smith. Here's why.

What is EPS?

The nice thing about EPS is that it's simple. It takes the annual profit after tax (but before preference dividends) and divides by the number of ordinary shares in issue. So if a firm makes profits of £20m and has issued 160 million shares, EPS is £20m/160m or 12.5p per share.

Clearly, the higher the result the better, but beyond that it's pretty meaningless in isolation. However, by looking at, say, the last five years of data, an investor can start to discern a trend (consistently rising EPS might suggest a well-run, growing business). What's more, it forms the basis of the much-quoted price/earnings (p/e) ratio.

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Do be aware that you can also get a slight twist on the basic published calculation the diluted EPS figure. This restates the basic EPS number to take account of all 'dilutive' events that have yet to take place, but that could theoretically increase the number of shares in issue. Examples include the directors choosing to exercise all their outstanding share options (which give them the right to buy new shares at a discount) or investors exercising all outstanding warrants (again these confer the right to buy shares). Another common dilutive event is the conversion of debt into equity by an investor, perhaps a venture capitalist. This would increase the number of shares on the bottom of the calculation and slightly boost earnings on the top (by reducing the current interest charge on outstanding debt). The overall effect is usually to reduce ('dilute') the quoted EPS figure.

That's fine, but since these dilutive events are theoretical until they actually take place, most investors focus on basic EPS. The trouble is, because high and rising EPS tends to be better than low EPS, directors will happily try to maximize the number using accounting sleights of hand. The share buy-back is a classic example.

Beware the share buy-back

Many companies, both here and in the US, are siting on cash right now. The problem they have in this uncertain economic environment is what they should do with it. Reluctant to invest heavily at a time when the economy could turn back down, an increasing number of companies are simply opting to return the cash to investors. After all, investors aren't paying the likes of BP to just sit on billions of their pounds uninvested it might as well be in the bank.

The question is how best to pay it to investors. One option is a special dividend (a one-off payout). However, plenty of firms prefer another option the share buy-back. That's because, on the one hand, it gets cash back into a shareholder's pockets (you are asked to return shares to the company which are then usually cancelled in return for money). On the other, it can provide a boost to EPS.

Imagine for example our firm is about to report EPS of 12.5p as per the earlier example. However, that's a bit low for the directors' liking, and not enough to justify their compensation packages at the annual general meeting of shareholders. So they authorise a buy-back.

Just before the end of the financial year, the firm buys back 30 million of its own shares from investors. The impact is to reduce balance-sheet cash and the number of shares outstanding to 130 million (160m-30m). Investors get an immediate cash payout. And secondly, reported EPS is now no longer 12.5p. It's £20m/130m, or just over 15p. But here's the rub EPS may have jumped, but the firm has not increased annual earnings by a penny. And all the while the directors have followed existing accounting rules so there's nothing officially dodgy about it.

Other accounting fiddles to watch

As noted above, Terry Smith chose to highlight share buy-backs recently. However, while popular, they are not the only trick used by directors to boost profits. In his book, he highlights a range of other possibilities. Here's just one depreciation changes. Under current rules, rather than write the cost of a long-term asset off against profits immediately when it is bought, a firm spreads the cost over many profit and loss accounts by choosing a useful economic life for it. So, for example, if a piece of plant is bought for £20m and given a useful life (based on its revenue-generating potential) of ten years, the annual depreciation expense deducted from profits is £2m.

Now let's say the directors decide to revise their estimate of how long the asset will last after the first five years. They then believe it has another ten years to run, not five as per their original estimate. The new depreciation charge becomes £10m/10, or £1m whereas the previous year it would have been £2m (£20m/10). So in the year the change is made, profits are boosted by £1m and so therefore is EPS.

What can you do about it?

Many investors will not relish the thought of having to unpick a set of accounts and work out how the directors may have boosted EPS. Fortunately there's no need. Cash flow is much harder (albeit not impossible) to manipulate than earnings. So a good bet is to check a firm's free cash flow per share (FCF/share).

This is the annual free operating cash flow after deducting the estimated amount needed to maintain fixed assets (the depreciation charge can be a proxy for this), divided by the number of shares in issue. If FCF per share and EPS are showing a consistent trend, you have at least some reassurance that EPS is reliable. Unfortunately, firms do not have to publish FCF/share data alongside EPS. However, it can be taken from sites such as Digitalllook.com or Hemscott.com.