In this article, we'll discuss why Earnings Per Share (EPS) is flawed in stock analysis, particularly when representing a company's profitability, financial health, or value. While EPS is a frequently cited figure in stock valuation and undoubtedly one of the most discussed financial metrics in the stock realm, its prominence is rooted in its accessibility on company income statements and its apparent simplicity in gauging a company's performance.

However, a deeper dive reveals numerous shortcomings in EPS, to the extent that long-term value investors might consider sidelining it altogether. This article will therefore unravel the nuances of EPS, shed light on its inherent flaws, and guide you towards alternative metrics better poised to assess a company's profitability, financial health, and overall value.

Understanding Earnings Per Share (EPS)

Earnings Per Share (EPS) represents the portion of a company's profit attributed to each outstanding share of common stock. Serving as a company's profitability indicator, investors frequently use EPS to gauge financial health and guide their investment choices. There are three main EPS types: Basic EPS, Diluted EPS, and Adjusted EPS, each offering different insights into a company's earnings in relation to its shares.

Basic EPS

The Basic EPS calculation is derived by taking the company's net income, subtracting dividends designated for preferred stockholders, and then dividing this value by the average number of shares outstanding during a specific period. This is shown in the formula below:

Basic EPS = (Net Income - Preferred Dividends​) / Weighted Average Number of Shares

where:

• Net Income: The company's total profit after all expenses, including taxes.
• Preferred Dividends: Dividends designated for preferred stockholders before any distribution to common stockholders.
• Weighted Average Number of Shares: The average number of shares outstanding during a specific period, accounting for share number changes over the reporting duration.

In short, this metric illustrates the portion of the company's income that shareholders could potentially receive if it were fully distributed as dividends.

Diluted EPS

Diluted EPS provides a broader view by incorporating potential additional shares that could come from securities like stock options, warrants, or convertible bonds. As the formula below illustrates:

Diluted EPS = (Net Income - Preferred Dividends​) / (Weighted Average Number of Shares + Dilutive Shares)

where:

• Dilutive Shares: Potential additional shares stemming from securities like stock options, warrants, or convertible bonds.

Due to these securities' dilutive impacts, Diluted EPS typically registers lower than Basic EPS, emphasizing potential dilution scenarios.

Adjusted EPS

Adjusted EPS aims to present a clearer view of the company's core operations by excluding profits or losses from non-central activities, as the formula below shows:

Adjusted EPS = (Net Income - Preferred Dividends +/– Non-Core Activities) / Weighted Average Number of Shares​

where:

• Non-Core Activities: Profits or losses from operations or events not central to a company's main business.

Often termed "headline EPS" or sometimes as "pro-forma", "normalized", or "core", Adjusted EPS provides insights into earnings from the company's primary functions, excluding one-time or non-core activity effects.

Comparing Basic, Diluted, and Adjusted EPS

Let's use a hypothetical company, ABC, Inc., to illustrate the differences between Basic, Diluted, and Adjusted EPS.

Below are our assumptions for ABC, Inc:

• Net Income for the year: $10 million
• Preferred Dividends paid: $1 million
• Weighted Average Number of Shares: 8 million
• Dilutive Shares (from stock options, convertible bonds): 2 million
• Non-Core Activities (gain from the sale of an asset): $500,000

From these numbers, we can calculate Basic, Diluted, and Adjusted EPS, as shown in the table below for ABC, Inc:

We can distinctly see the nuances between the three types of EPS calculations:

• Basic EPS: Provides a clear representation of the company's earnings based on its regular shares, resulting in an EPS of $1.12. This gives investors an immediate understanding of the earnings per regular share, assuming no additional shares are added to the mix.
• Diluted EPS: Takes into account additional shares that could come into play due to convertible instruments. As these additional shares are accounted for, we observe a reduced EPS of $0.90. This is especially crucial for potential investors who wish to factor in the worst-case scenario of dilution.
• Adjusted EPS: Refines the picture further by removing the effects of non-core activities. In ABC's case, a gain from the sale of an asset is subtracted from the net income, which results in an EPS of $1.06. This version of EPS offers an insight into the earnings from the company's primary operations, excluding any one-off events or transactions.

So, while ABC, Inc. appears to have a healthy Basic EPS, potential dilutions could affect their earnings to a noticeable extent. Moreover, by focusing solely on the core operations, the Adjusted EPS provides a more conservative and perhaps a more accurate representation of the ongoing profitability.

At the heart of all three EPS calculations (Basic, Diluted, and Adjusted) is the net income and share count. Each method considers the net income and divides it by a respective share count, whether it's the basic number of shares or an adjusted count that factors in potential dilutions or non-core activities. Yet, no matter which EPS method is in focus, even if Diluted and Adjusted EPS offer more precise insights, there remain inherent flaws in the overarching concept of EPS. We'll delve into these limitations in the following section.

Six Key Flaws of Earnings Per Share (EPS)

The six reasons on why Earnings Per Share (EPS) is flawed are described below.

Flaw #1: Vulnerability to Accounting Choices

EPS can be heavily influenced by the accounting choices a company makes:

• Varied Accounting Policies: Different organizations might adopt distinct accounting standards, like GAAP or IFRS. The nuances between these standards, such as differences in "asset revaluation practices," can impact how earnings are reported and thus skew EPS values.
• Revenue Recognition Practices: The methodology by which companies recognize revenue can vary, affecting the timing and quantum of reported earnings. Such discrepancies in revenue recognition can introduce significant variations in the net income, altering the EPS.
• Discretion in Provisions: The latitude companies have in setting provisions for uncertain future costs, such as doubtful accounts or warranties, allows them to potentially manipulate net income, which in turn can influence EPS.

In light of the inherent flexibility in accounting practices, investors should exercise caution when relying solely on EPS as an indicator of a company's performance or value. It's essential to delve deeper into the accounting policies and methodologies adopted by organizations to ensure a comprehensive understanding of reported earnings.

Flaw #2: Vulnerability to Structural and Strategic Choices

EPS is also notably sensitive to changes in net income and share count, opening avenues for financial engineering:

• Share Buybacks: Companies, by repurchasing their own shares, can boost their EPS. This is achieved as buybacks reduce the number of outstanding shares, leading to a higher EPS value for the same net income. Apple (AAPL), for example, is notorious for massive share repurchase programs, which regularly influences its reported EPS numbers.
• Stock Splitting: Stock splits, while not changing the intrinsic value of a company, alter the share count. If not accounted for correctly, the resulting EPS can mislead investors.
• Exceptional Adjustments: The EPS can also be influenced by what companies define as 'exceptional' while presenting their adjusted EPS. The subjective nature of these adjustments, such as excluding major restructuring costs, can provide a skewed perception of a company's profitability.
• Mergers and Acquisitions: EPS values can be significantly affected by M&A activities. These deals highlight how EPS can be artificially inflated, not necessarily reflecting genuine value addition but rather benefiting from financial synergies.

Given the susceptibility of EPS to various financial maneuvers, investors must critically assess the factors driving its changes. It's imperative to understand the underlying reasons, whether from share buybacks, stock splits, unique adjustments, or M&A activities, to discern between genuine profitability and mere financial engineering.

Flaw #3: Overlooking Long-Term Value for Immediate Profitability

EPS, while providing an immediate snapshot of profitability, often overshadows the importance of strategic investments that fuel long term value. Companies, in their quest to present favorable short-term earnings, might shy away from ventures like research and development (R&D) or corporate giving. Although these might depress EPS in the interim, they are pivotal for future innovation, sustainability, and establishing an economic moat.

An undue fixation on EPS can sometimes drive companies toward decisions that may offer short-term cost savings but have adverse long-term consequences. Scaling back on R&D, curtailing employee benefits, or cutting corners in customer service are some of the potential pitfalls. These decisions not only hinder future growth prospects but can also tarnish brand reputation.

Consider the trajectory of companies like Amazon (AMZN) and Tesla (TSLA). In their nascent stages as publicly-traded entities, their heavy reinvestments in research, infrastructure, and expansion often resulted in modest or even negative EPS. The illustrative journey of Tesla to an eventual positive EPS is shown below:

As you can see, it wasn't until 2020 that the company achieved a modest positive EPS of 0.25, having posted negative figures since its 2010 IPO. While Tesla might have achieved positive EPS sooner by cutting back on SG&A and R&D expenditures, doing so could have hampered its journey to become an electric vehicle market leader, currently boasting revenues exceeding $81.5 billion. Investors fixated on immediate returns might have found early EPS numbers unsettling. However, those with vision and persistence have been richly rewarded, as Tesla's initial investments paved the way for its eventual market dominance.

Additionally, in the race to optimize EPS, companies may sideline broader corporate social responsibilities (CSR). Initiatives that don't immediately boost EPS, such as environmentally-friendly projects or community engagement, might be put on the back burner.

However, the long-term implications of these decisions can be vast. Engaging in CSR not only enhances a company's reputation but also establishes stronger ties with stakeholders. Activities like investing in green technologies or community outreach may not instantly lift the bottom line, yet over time, the intangible benefits (enhanced brand loyalty, motivated workforce, potential tax incentives, etc.) can significantly contribute to sustainable growth and shareholder value.

Flaw #4: Limited Scope in Stock Valuation

While EPS provides a snapshot of a company's profitability on a per-share basis, it doesn't capture the entire valuation landscape. A key complement to EPS in stock valuation is the Price-to-Earnings (P/E) ratio, which is calculated by dividing a company's current stock price by its EPS. This popular metric indicates how much investors are willing to pay for every dollar a company earns. A high EPS might seem attractive, but when coupled with a significantly high stock price, it could lead to a high P/E ratio, possibly signaling an overvalued stock.

When we delve deeper into the dynamics between EPS and stock valuation, several nuances come to light:

• Market Conditions: EPS isn't always reflective of broader market conditions. During bullish phases, stock prices might surge, inflating P/E ratios even if EPS remains stable. Conversely, in downturns, even a strong EPS might not prevent a stock's P/E ratio from plummeting.
• Growth Prospects: A high EPS doesn't necessarily herald future growth. Companies in their prime might report high EPS figures due to efficient operations, but their growth potential might be limited. In contrast, a rapidly growing company might have a modest EPS but massive growth prospects, justifying a higher valuation.
• Dividend Policies: EPS doesn't reveal how profits are distributed among shareholders. Firms that offer substantial dividends might be more enticing to investors who seek regular returns, regardless of market volatility.
• Earnings Quality: The origins of earnings also matter. A surge in EPS might result from one-time events, like asset sales, rather than consistent business operations. Earnings stemming from regular operations are typically seen as a more stable indication of a company's health and its potential for growth.
• Industry Comparisons: It's essential to remember that EPS figures can greatly differ across sectors. A fledgling tech company might report a low EPS due to significant R&D investments, while a seasoned manufacturing firm might consistently display high EPS figures. Direct comparisons between such diverse industries might misguide investors.

In summary, relying solely on EPS for stock valuation can lead to a narrow perspective, possibly overlooking the true potential of a company in the market.

Flaw #5: Ignoring Financial Health Indicators

Another important dimension that EPS doesn't capture is the company's debt profile and financial leverage. While leveraging can amplify returns in good times, it can also intensify losses during downturns. A company with high EPS but also significant debt might be riskier than one with a slightly lower EPS but a more conservative debt profile. For instance, during the 2008 financial crisis, many companies with high leverage ratios faced significant challenges, even if their EPS figures before the crisis looked favorable.

Additionally, cash flow is a critical determinant of a company's financial health, and EPS doesn't account for this. Earnings, as reported on the income statement, can include non-cash items like depreciation and might be influenced by various accounting practices. On the other hand, cash flow provides a clearer picture of the actual cash generated or used by a company's operations.

An example that illustrates the limitation of relying on EPS without considering debt and cash flows is the case of Bed Bath & Beyond, as shown below:

The visual provides a snapshot of the financial missteps that led Bed Bath & Beyond towards delisting and bankruptcy. While the company displayed a modest uptick in its EPS, a misjudgment occurred in 2015 when it opted to issue $1.5B in bonds to repurchase stock. This decision was made against the backdrop of an already lackluster cash flow from operations, which only further deteriorated following this ill-advised managerial choice.

Flaw #6: Lack of Adjustment for Inflation

In an inflationary environment, the nominal values of many financial metrics, including revenues and earnings, tend to rise. This increase is not necessarily indicative of real growth or improved operational performance but rather a reflection of the reduced purchasing power of money. When prices for goods and services rise due to inflation, companies might report higher revenues and potentially higher earnings, even if they haven't sold more products or improved efficiency.

Take, for example, a scenario where a company announces a 10% increase in its earnings. On the surface, this might appear impressive. However, if this announcement comes during a period when inflation stood at 7%, the real, inflation-adjusted growth of the company is a mere 3%. In such a context, the unadjusted EPS figure paints an overly rosy picture of the firm's financial health.

Investors who do not account for inflation when analyzing EPS run the risk of making misinformed decisions. They might overvalue companies that appear to be thriving when, in reality, their growth is largely a product of inflation rather than genuine business expansion or efficiency gains.

Furthermore, for companies that have fixed-interest debt, inflation can also create the illusion of increased earnings. This is because, in nominal terms, their interest costs remain constant, but in real terms, the burden of this debt diminishes with inflation. In simpler terms, even though the amount they owe doesn't change, the actual value of that amount becomes less due to inflation, making it easier for companies to handle their debt. While this may boost EPS in the short run, it does not necessarily reflect an improvement in the underlying business operations.

Alternatives to Earnings Per Share (EPS)

For investors seeking clarity beyond the limitations of EPS, what alternative metrics should be considered? While no single metric is flawless, a combination of the suggested alternatives can collectively address the primary shortcomings of EPS, offering a more comprehensive perspective.

Owners Earnings

Owners earnings, often equated with free cash flow (FCF), provide a holistic view of a company's true cash-generating potential. This metric is a leading alternative to EPS. It quantifies the cash a company generates after deducting capital expenditures from its operational cash flow, highlighting the company's potential for growth, dividend distributions, and debt servicing.

Warren Buffet popularized the term "owners earnings" in his 1986 Berkshire Hathaway shareholder letters. His methodology to calculate owners earnings involves adding back non-cash charges, such as depreciation and amortization, to net income and then deducting capital expenditures. This formula is shown below:

Owners Earnings = Net Income + Non-Cash Charges - Maintenance Capital Expenditures (CapEx)

where:

• Net Income: The company's total profit after all expenses, including taxes.
• Non-Cash Charges: Includes depreciation, depletion, amortization, impairment charges, and any other non-cash charges.
• Maintenance CapEx: Money a company spends to maintain the normal operations of the business.

This approach offers a clear view of the actual cash available to shareholders, shedding light on the company's financial strength. Furthermore, Buffett's concept of owner's earnings can be further refined using the following alternative formula:

Owners Earnings = Operating Cash Flow - Maintenance Capital Expenditures (CapEx)

where:

• Operating Cash Flow: Cash generated from the normal operations of a company.

The distinction between the two formulas is the substitution of "net income + non-cash charges" with "operating cash flow" from the cash flow statement in the latter. This adapted formula usually yields a more precise result since net income can be subject to accounting manipulations and non-cash charges can vary among firms.

One of the challenges with both formulas is accurately estimating maintenance CapEx. Typically, companies display the full CapEx, also known as Plant, Property, and Equipment (PP&E), under the Investing section of the cash flow statement. This encompasses both growth and maintenance CapEx, and often, the delineation between the two is either unclear or not stated at all

A straightforward and conservative method is to treat all of CapEx as maintenance capex. This is the basis of the simple free cash flow (FCF) calculation: operating cash flow minus capital expenditures. For a more precise maintenance CapEx figure, I suggest reading my comprehensive article on calculating and analyzing Warren Buffett's owner's earnings, where I delve deeper into the subject.

In closing, instead of relying solely on EPS, focusing on owner's earnings equips investors with a more tangible grasp of the funds a company can allocate either for direct shareholder benefits, like dividends or stock buybacks, or for reinvestment to achieve greater returns on invested capital (ROIC).

Gross and Operating Margins

Profit margins, including gross and operating margins, are essential indicators for investors assessing a company's operational efficiency. They reveal how efficiently a company can create goods/services and handle its primary functions. A trend of increasing margins generally points to enhanced business efficiency, while decreasing margins might suggest emerging operational hurdles.

The gross profit margin shows the portion of sales revenue that remains after covering the cost of goods sold:

Gross Profit Margin = (Gross Profit​ / Revenue) * 100

where:

• Gross Profit: This is what's left when you subtract the cost of goods sold (COGS) from sales. COGS encompasses the direct costs tied to the production of a company's goods or services, like material costs and labor.
• Revenue (or Sales): The total earnings from a company's main activities before any expenses are removed.

A high gross profit margin means the company keeps more from each sale after accounting for production costs.

The operating profit margin, on the other hand, measures how much revenue remains after both the cost of goods sold and all operating expenses are considered:

Operating Profit Margin = (Operating Income / Revenue​) * 100

where:

• Operating Income: This is the profit from a company's core activities. It doesn't include interest or taxes but considers operating expenses like wages, rent, and utilities.

When the operating margin is high, it suggests the company is efficiently managing its operating costs in relation to its sales.

Assessing both gross and operating profit margins is essential because they provide insights into different facets of a company's financial performance. While the gross margin reveals the efficiency of production and direct costs management, the operating margin offers a broader view, encompassing the company's ability to manage its core operational expenses.

While these margins are crucial, it's also beneficial to scrutinize other significant operating expenses, such as the sales, general, and administrative (SG&A) expense line item. If SG&A expenses rise faster than revenues, it might be a red flag. Ultimately, delving deeper into profit margins, rather than just focusing on EPS, can give investors a more comprehensive view of a company's financial well-being.

Valuation Multiples

For investors seeking a more holistic understanding of a company's valuation, it's essential to look beyond just the EPS. One such alternative is the EV/EBITDA ratio, which compares a company's entire value, including its debt, to its earnings before considering interest, taxes, depreciation, and amortization. This ratio is especially valuable for assessing companies with different debt profiles or those in industries with substantial asset bases.

In addition to EV/EBITDA, the P/E ratio offers further insights into stock valuation. While EPS gives a snapshot of a company's earnings per share, the P/E ratio places this in the context of the stock's market price, reflecting how much investors are willing to pay for each dollar of those earnings. As previously discussed, this offers a clearer perspective on valuation. Both of these metrics, when compared to EPS and in conjunction with other valuation multiples, offer a more holistic understanding of a company's financial standing.

It's crucial, however, to look beyond just the numbers. Successful investing hinges on understanding the dynamics shaping these metrics and focusing on their forward-looking implications, which can hint at future prospects rather than just reflecting past performance.

The Bottom Line

Earnings Per Share (EPS) is a widely recognized metric, but it's riddled with limitations that can mislead investors. Its vulnerability to accounting choices, susceptibility to financial engineering, and inability to capture long-term value creation are just a few of its inherent flaws. Moreover, EPS often overlooks critical financial health indicators and doesn't adjust for inflation, potentially painting an overly optimistic picture of a company's financial health.

While EPS can provide a snapshot of immediate profitability, it's essential for investors to delve deeper, considering alternative metrics like owner's earnings, profit margins, and valuation multiples. By adopting a holistic approach and understanding the nuances behind these metrics, investors can make more informed decisions, ensuring they capture the true essence of a company's financial standing and potential.