How to Evaluate the Quality of EPS

It can be hard to decipher what a company’s earnings per share (EPS) report actually means. On top of that, management has a variety of ways in which they can potentially manipulate earnings per share numbers in their favor. This article will show you how to evaluate the quality of any kind of EPS to find out what it's telling you about a stock and to potentially protect yourself as an investor.

The evaluation of earnings per share should be a relatively straightforward process, but thanks to the magic of accounting, it can become a game of smoke and mirrors, accompanied by constantly mutating versions that seem to have come out of "Alice in Wonderland." Instead of Tweedle-Dee and Tweedle-Dum, we have GAAP and non-GAAP EPS figures that form the bottom line after some in-depth considerations on the income statement for direct costs, indirect costs, and EBIT. Investors will generally get some preview of these expectations through previous guidance, a whisper number or consensus point, but the real numbers are never known until the report is released.

To be fair, the clouding of EPS reporting cannot be totally blamed on management. Wall Street also deserves some blame due to its myopic focus on the near-term, and knee-jerk reactions to 1 cent misses. A forecast is always only a guess—nothing more, nothing less—but Wall Street often forgets this. This, however, can create opportunities for investors who can evaluate the quality of earnings over the long run and take advantage of market overreactions.

Before you can analyze the quality of EPS, it is important to start with a simple breakdown of what EPS is. EPS is the bottom line on an income statement that shows a company’s total net income divided by its shares outstanding. The income statement is typically broken into four parts. First, a look at the company’s direct costs which results in net revenue and gross margin. Second, a look at indirect costs which results in operating income, also known as earnings before interest and tax (EBIT), and operating margin. Third, the net income which is the company’s earnings after subtracting interest and tax from EBIT. Lastly, a breakdown of earnings per share.

The final portion of the income statement which focuses on earnings per share breaks out the earnings in two ways. Public companies report basic earnings per share and diluted earnings per share. Basic earnings per share is generally the net income divided by the free float, active shares in the market. The diluted earnings per share is the net income divided by the total shares available including free float and convertible shares. Companies and the media usually focus on the diluted earnings per share.

The EPS portion of the income statement is also often adjusted based on non-GAAP measures. Companies can potentially manipulate the EPS number through its management of shares or its adjustments using non-GAAP items.

A high-quality EPS can mean that the number is a relatively true representation of what the company actually earned. This will usually come with very few non-GAAP earnings adjustments. It also may involve a company’s earnings recognition strategy. Earnings recognition strategies will vary by industry and company. These strategies can easily be overlooked but are important to understand when evaluating the quality of EPS. EPS may also be considered of higher quality when a company is improving its expense management and increasing its margins.

Higher expenses, a lot of non-GAAP adjustments and unnecessary shares outstanding changes can be flags for low-quality EPS reports. Management can alter shares outstanding through new issuance and buybacks. Accounting standards also provide for latitude in the area of revenue recognition. Nonetheless, companies must be ethical in their EPS reporting. Working outside of the standards for revenue recognition specifically can lead to management problems and lawsuits such as the case for Enron and WorldCom.

EPS is a byproduct of a company’s earnings, so overall there are a few ways to evaluate EPS. Looking at the income statement can be important for understanding the expenses of the company and how expenses are managed. Gross margin, operating margin, and net margin are all helpful for evaluating expenses at different phases of the income statement.

Using comparisons can also be helpful for evaluating EPS quality. An EPS number in isolation is only the result of a company’s reported revenue minus expenses divided by shares outstanding at any given time. Therefore, it can be important to look at EPS from different angles. Some investors breakdown EPS similar to margins so they can look at net revenue per share or EPS from continuing operations. It can also be important to look at EPS growth and compare EPS across the industry. If EPS is spiking or growth is far higher than comparable companies there should be some explanations for why.

Investors can also potentially turn to the cash flow statement and operating cash flow in particular for some analysis of earnings quality. Some investors analyze operating cash flow and operating cash flow per share in comparison to EPS. Generally, investors would like to seek operating cash flow per share higher than EPS.

Comprehensively, if a company’s EPS is growing without an increase in operating cash flow or with negative operating cash flow then this can be a flag. In some cases, it can mean high operating charges possibly from unrealized revenue receivables. It may also be the result of high levels of depreciation or amortization over the long-term. Negative operating cash flow may also require deeper analysis into debt levels, days sales outstanding, and inventory turnover. As the saying goes, "cash is king" so it can be a cause for concern if operating cash flow is showing some challenges while earnings are growing steadily or at a faster pace than in the past.

As discussed, it can be important for investors to look at EPS from different angles. As such, trends can be an important factor in analysis. It is possible that an entire industry may have increasing or decreasing EPS growth due to macro variables affecting the industry as a whole. A company may also be beating or falling behind trends because of new introductions or increased capital expenses. Companies may also be reporting decreases in pro forma operating cash flow versus future EPS expectations. A multitude of factors can affect the EPS analysis of a company, the EPS growth of an industry, and operating cash flow. In some cases, a company may also have one low or high quarter due to new strategic investments or idiosyncratic factors.

Evaluating trends can help to spot different types of scenarios. In some situations, there may be legitimate reasons for discrepancies and downtrends (economic cycles, the need to invest for future growth), but if the company is to survive, problems cannot last long.

A company’s EPS report usually attracts a lot of attention. It provides the bottom line earnings results for a company and is one of the key measures of performance for a company on a quarterly or annual basis. Since it does attract a lot of attention, management and investors place a lot of importance on it. From management’s perspective, executives can use a variety of techniques to potentially manipulate EPS in their favor. Investors are subject to this, however, so it can also be important for them to have a good understanding of what EPS represents and the ways to analyze it in order to realize the quality of earnings.

Markets overall are known for being efficient. Thus, the efficiency of the market usually leads to higher valuations for companies with growing, high-quality earnings and lower valuations for decreasing earnings or earnings of low quality. While management can use certain techniques to adjust EPS in their favor, investors and the market will usually not allow for discrepancies over long periods of time. Steadily degrading quality of earnings will often result in activist intervention and/or shareholder lawsuits which seeks retribution for overlooking the best interests of the shareholders in management EPS strategies.