OLD ARTICLE – Originally posted on September 23, 2016
When investing in a listed share, you are buying part of a business and own a portion of its future profits (or losses). Therefore, the per share earnings of a listed company are a big deal for investors with shares rising and falling base on them (or at least the expectations of them).
Typical of our murky financial world, though, listed companies often report numerous per share measures of earnings with their bi-annual set of results.
Which ones should you be looking at?
Broadly speaking, there are two major types of per share earnings: IFRS-defined ones and non-IFRS (or “adjusted earnings”) measures.
The International Financial Reporting Standard (IFRS) is the accounting framework upon which companies account for and report on their financial transactions. Within this quite strictly defined standard(s), there are three major types of per share earnings that companies must report:
- Earnings Per Shares (EPS): This is the least adjusted earnings measure where the company takes its total profits attributable to shareholders and divides it by the weighted average number of outstanding shares during the period. EPS is always both important and noisy. For a super stable business, like British American Tobacco (BTI), I’d say EPS is quite key, but for volatile for fast moving businesses, this measure is often too noisy to help much.
- Headline Earnings Per Shares (HEPS): The problem with EPS is that IFRS has rules where lots of funny non-cash adjusted get pushed through the earnings of a company, in some cases quite seriously distorting them. Likewise, various non-operational items can occur that also distort the profits. For example, a manufacturing business sells excess land and records a profit, but that profit won’t exist next year and has nothing to do with the business’s normal day-to-day business. Therefore, Headline Earnings Per Share (HEPS) first takes out a defined list of “non-operational” profits and losses from a company’s earnings before calculating its per share earnings. Thus, the idea is that HEPS should reflect how the actual underlying businesses performed without non-operational distortions clouding the picture. See here the defined rules for Headline Earnings. HEPS is quite key for businesses that are experiencing a lot of unusual business activities, for example, a restructuring that is incurring lots of once-off costs and impairments. In this example, the HEPS figure will allow to work out how the actual business is doing despite all this noise.
- Diluted Earnings Per Share / Diluted Headline Earnings Per Share (DEPS/DHEPS): The key to understanding this per share earnings measure is the word “diluted”. Companies often have shares they have promised to issue, committed or perhaps even liable to issue, but have not actually physically issued yet. Perhaps a company makes an acquisition with a profit warranty that will only be known in three years time and will be paid in shares. In this case, there are potentially issuable shares, thus in the calculated of the “diluted” part of DEPS/DHEPS a company assumes that they have already issued out all potential shares already. In this case, IFRS is trying to measure all dilution that existing shareholder may have to absorb. Consider reading this note on DEPS. DEPS is important for companies that issue (or promise lots of) potential shares, for example, EOH Holdings (EOH) and AdaptIT Holdings (ADI) are both acquisitive via script and have outstanding profit warranties on acquired businesses and perhaps even Ascendis Health (ASC).
And now here is the magical rule: All other per share earnings metrics reported by companies are where directors have ignored accounting rules and manipulated their earnings to appear how they want them to.
All these are the “adjusted earnings” measures and have no rules attached to them.
So are they all rubbish? Can we trust them?
Well, because none of these “adjusted earnings” measures are formally defined, the starting point to forming an opinion on them is to look for what management’s definition is. (If the definition is not disclosed, then burn the set of results, delete the share off your watchlist and pretend it never existed in the first place, because this set of management is either stupid or dishonest. Either way, you want nothing to do with this sort of company.)
I hope that makes sense?
In summary, all per share earnings measures can be summarized as either IFRS-defined or management “adjusted” ones. While IFRS measures can be “trusted”, their rigid definitions also make them sometimes meaningless. Therefore adjusted earnings measures can be useful for investors, but always work your way through management’s definitions of these measures before deciding whether or not it is just window dressing.
After all, not all adjusted earnings are of the same quality for decision-making…