What does 'earnings per share' mean? - MoneyWeek Investment Tutorials

so in this video we're going to take a look at a vital number for investors earnings per share it's a number that analysts concentrate quite a lot of time on it's a number that the management of companies likes to try and get right because they know that many investors will use it as a guide to performance over time so what is it how many versions are there and I'll be saying there are basically two and is it useful and the answer is well yes it is but you have to be careful as with all accounting numbers it's flawed okay so what is earnings per share well in essence it does what it says on the tin it's also known as EPS it is one year's earnings so that's profit after tax we're not going to be taking away dividends and that's simply because the directors make a decision about how they distribute profits after tax either their dividend or they don't but that doesn't influence the earnings for the year so we're going to ignore dividends if you like take profit after tax and divide by the number of ordinary shares voting shares if you will in issue and that's going to give us e PS or earnings per share in its what you might call basic form okay so the basic calculation is on the face of it straightforward what you would do as an introduction if you like is simply take the profit after tax figure let's call that 10 million and divide it by the number of shares currently in issue we'll say 100 million for this sort of simple example and on that basis EPS is going to come out as a number of pence or pounds even per share so 10 million over 100 million is simply 10 pence or 10 pence per share now by itself that doesn't really tell you very much obviously the higher the better from a shareholders perspective but is useful to look at a trend for example so you might start to look back over the last three or four and see how EPS has developed the other use for it something we look at in a different video is in a price to earnings multiple because that multiple used as a way of deciding whether a share is cheap or expensive uses the current share price divided by the latest earnings per share figure so for example the current share price is a pound EPS based on the latest earnings is 10 P then the p/e multiple would be 10 because I say that's something we cover in another video now is that the end of the story well that's what they call basic earnings per share the calculation certainly looks fairly straightforward just be aware that companies publish least one other version normally because they're required to in the UK and that's called the diluted earnings per share figure so just be aware that there is a thing called diluted EPS as well now what that does is it says well actually do we have the full picture here is this a true earnings per share figure or not and the full picture means how would this look if all potentially dilutive events in share price terms happen now and so what we're saying there is what if for example there are share options outstanding some of the directors may have the right to demand new shares as part of their pay packet they haven't exercised that right yet but what if they did would that change earnings per share and do investors need to know the effect so diluted earnings per share would say well actually maybe existing options could create another for argument's sake 10 million shares and if that's the case 1 year's profit after tax for the last 12 months won't change but the bottom of this formula does so you can see that's going to pull down my 10 P okay so diluted earnings per share looks at things that might create more shares and therefore bring down this ten people share these events haven't necessarily happened yet that's thought to be useful to shareholders to get a picture as to what could happen to earnings per share other examples of dilutive events warrants outstanding pieces of paper that allow you to buy shares suddenly being exercised or the conversion of debt into shares now what would that do well if a company's got debt outstanding and the people who've lent the money have decided rather than have it paid back they'd like to take some shares in the company instead literally convert what would happen is on the balance sheet debt would disappear and suddenly the number of shares issued would rise so here what that would do is it would boost profit after tax a little bit because suddenly we don't have an interest charge on the debt going through the profit and loss account and it would increase the number of shares an issue it would still unbalance probably be diluted now what that means is the 10p would drink of it so to be honest for most investors diluted earnings per share is a matter of interest rather than being essential basic earnings per share is what a lot of investors track but just be aware that there are one or two versions of it now it's useful as a guide to performance over time it's the basis for the price earnings ratio but is it flawless no there are at least a couple of problems with earnings per share and it's worth being aware of what they are one of them was flagged recently by fund manager Terry Smith he's unhappy with earnings per share in one respects so let's have a look at some some issues here so problems with the earnings per share calculation one of them share buybacks now a share buyback is a company that's got a lot of cash on its balance sheet thinking do you know what I'm not going to invest it a lot of people are sitting around waiting for footsie 100 companies to start investing again but the climate may be too uncertain so I'm not gonna invest it I can't sit on it because I'm not a bank my shareholders not paying me it's just whole cash I don't fancy paying out any more by way of dividends so I'll simply buy back some shares but he might say well it sounds like a reasonable strategy when it comes with a twist and earnings per share is that twist let's put those numbers back up again so my earnings per share figure was profit after tax of 10 million divided by a hundred million shares and that gave me 10 P or 10 people share share buyback quite a cunning move this one is look what happens basically the directors write a check to buy back let's say 20 million shares effect on this ratio profit after tax still the same one year's profit after tax from the profit and loss account anyone wondering about profit and loss account there is a separate video called what is profit describing that number in a bit more detail but that won't change as a result the share buyback but this will in very very simple terms you're going to decrease the number of shares outstanding by buying some back and that is going to boost this number for no extra earnings so in other words it's quite a simple trick and the accounting rules allow it the directors can achieve a kind of one-off boost to earnings per share through a share buyback having not actually generated one beam of extra profit in the business and that's just something to watch out for always worth keeping an eye on share buybacks will have that quite nice boosting effect on EPS and there's another problem it is with the earnings figure being used because it's the profit figure alpha tax lots of things have been deducted to get to it and some of them are quite subjective so for example you've deducted the depreciation of fixed assets that's essentially an estimate by the directors of how long they'll last and a charge on the back of that in each year's profit and loss account to reflect the kind of wearing out those assets amortization does a similar job on intangible assets such as goodwill now those sound as wofully as they are if you like and they've been charged in arriving at the earnings figure used in EPS so some analysts are not so keen on earnings per share for that reason and basically the solution is you either try and sort of fiddle around with earnings per share to take out items you're not fully comfortable with the more subjective ones for example that have been charged in the profit and loss account or maybe you switch a target altogether and that's why some analysts prefer something called free cash flow per share basically some investors and I have some sympathy this is quite a useful number we'll switch their attention from earnings per share saying well the only speaker is up is really two two floored it's based on a lot of accounting judgments whereas cash flows a little bit harder to manipulate so rather than EPS you get F CF s if you like free cash flow per share that's not something companies publish as a matter of course and to bolt it together what you'd need to do is go to the cash flow statement that's the one that appears after the profit loss cam balance sheet you would normally take the operating cash flow that's the cash being generated by the the heart of the business if you like and that's normally after things like interest charges on debt you would take that operating cash flow and knock off a little bit for it's N actual capital expenditure on the basis that what's left is what the directors have to play with it's the stuff that they can choose to some extent how they allocate so free cash flow per share something we'll pick up in another video but essentially says actually EPS isn't really good enough so instead let's take operating cash flow deduct a little bit for essential capital expenditure on the basis that to run a business you've got to spend something on maintaining fixed assets by the way a proxy for that is the depreciation expense for the year but only a proxy so we'll take out what we might call essential capex and then we'll divide by the number of shares in issue maybe the hundred million again and that will give us in pence cashflow per share rather than earnings per share so earnings per share is the one that's published it's the one that people talk about a lot of the time and frankly it's not a bad guide to how a business is doing over time and it is an icky component of the price earnings ratio but be a little bit careful it can be influenced just like all it that why things like share buybacks by decisions made about depreciation and amortization in the profit and loss account for example and therefore you will find some commentators switching to another measure free cash flow per share on the basis that cash flows a little bit harder to tweak by the directors and perhaps it's a truer measure of the business's underlying performance

Channel: MoneyWeek

Views: 121,831

Keywords: instructional video, educational, finance, investments, earnings, per, share, eps, tim, bennett, moneyweek, monerweekvideos

Id: vksGv_7sdIA

Length: 12min 56sec (776 seconds)

Published: Thu Apr 21 2011