It is usually assumed that EPS is a widely used indicator for investors’ ratio – price earning ratio (P/E ratio). P/E ratio is often used to value of investment decisions, such as buying/ selling shares, mergers & acquisitions and public listing exercises. Somehow, there are significant limitations imposed on EPS quality and usefulness.
Creative Accounting/ Impression Management
EPS is only considered high quality when it is “relatively true representation of what the company actually earned.” -- Rick Wayman. There are many strict standards and regulations about how to report the earnings of a company in its financial statements. However, there are ways that easily distort the reported EPS by simply applying various measuring standards (e.g income recognition, depreciation method, off-balance sheet financing, etc) that fits the purposes of the company with the effect of any creative accounting. Unethical companies may use EPS information to influence the investors and market expectation by smoothing out EPS trends.
Cash (from operation) is KING, not profit
The best way to evaluate quality is to compare operating cash flow per share to reported EPS, because cash is “king” not profit. The excess cash from operation can be utilised to purchase new fixed assets or to reward shareholders in the form of dividends. If operating cash flow per share is less than EPS, it means that the company is generating less cash than reported EPS. In this case, EPS is of low quality because it does not reflect the negative operating results of the company and overstates what cash operating results.
Comparability
EPS of one entity cannot be compared with another entity because the denominator of the number of shares is not comparable. Any attempt to make inter-entity comparisons will necessarily involve the risk of erroneous conclusion to be drawn. EPS may not be comparable over time because of changes in owners’ equity structure (e.g shares placement, shares buyback, shares dividend and shares split). While the addition of diluted EPS provides partial mitigation, considerable care is needed when comparing EPS numbers of an entity over time.
Non-financial consideration
The other sources of information used to analyze quality of EPS for investment decision making are management's strategic plan, business projects plan, production capacity information, sales and marketing information. Management could also indicate the course of action that the company has taken or proposes to take remedy on material deficiency EPS. Investor should have kept a watchful eye on its financial performance and management's strength, in order to make a good investment decision.
Macro view
The investors should also have a general view of market conditions and the overall business environment. A negative cash flow and EPS may not necessarily be illegitimate, investors should analyze the EPS trend in relation to industry trends. Investors can also compare the unfavourable performance of the company within the same industry to identify business cyclical.
To conclude, EPS as a sole indicator itself does not indicate much information for investor. Making investment decisions requires not just figure of EPS but all types of information include past, present and future information as well as evaluating the cash flow. General view of market conditions, overall business industry environment, current business and world economics events play an important role in the process. However, the difficulty is getting all the information is a timely, costly and concise manner between those who have it and those who need it for investment decision making.
