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Reported EPS figures may be of no investor value

I’d noted that Info Edge reported its EPS figures wrong. Unfortunately they may be legally allowed to report wrong EPS figures – because they are allowed to take a “weighted average” number of shares into consideration.

Example: If a company has 100 shares for the first six months of the year, and issues 50 shares more after six months, it will have 150 shares for the last 6 months of the year. (Assuming no other dilution) So if hte company earns Rs. 7,500 in profits, you would think the EPS is Rs. 50 per share (7500 divided by 150). But the company will report it as Rs. 60!

Funda is: The average number of shares for the year is 125 shares (100 for half the year, 150 for the other half). That means the net profits (rs. 7500) is divided by 125 shares instead, to get a figure of Rs. 60 EPS. (For more details on how the calculation works, check this page)

But how good is that to you, the investor? If you consider the EPS of Rs. 60 per share, and expect that the company will grow 20% in the year, what you expect the EPS to be next year? Rs. 72. And based on that you pay a p/E of 20 for the share – paying Rs. 1,200 per share.

Next year the company grows 20%. From Rs. 7,500 in profits it grows to Rs. 9,000 in profits. You rub your hands in glee, practically counting your money from the gains. But, to your dismay, the reported EPS figure is just Rs. 60! The profit grows 20%, but the EPS has not grown at all!!! The share price, looking at this, can even fall lower than the 1,200 you paid – after all, who will want to give a 20 P/E company whose EPS has not grown at all in the last one year?

This is the exact situation with companies that have gone for IPOs last year. Naukri, whose IPO was in November 2006 (Q3), has shown results like so:

Q1: 5.22 cr.
Q2: 3.56 cr.
Q3: 8.1 cr.
Q4: 10.13 cr.

Most of the income has come from the second two quarters, out of which “other income” formed a huge amount (5.3 cr. in the last two quarters). Most of that “other income” would be related to IPO proceeds plus the amounts received as pre-IPO investment in September 06.

Using weighted EPS figures is of little significance here, since the earnings are not equal across quarters. but that’s not the real problem.

Let’s say Info Edge grows by 50% next year. They will then make net profits of Rs. 40.62 cr. next year. That, assuming today’s number of shares (2.7295 cr.), will yield an EPS of 14.88. EPS therefore has grown from today’s value of Rs. 11.31 to 14.88, a growth of 31.6%.

The P/E, at a 14.88 EPS, is a little more than 50. Which, as you can imagine, is much higher than the EPS growth using reported numbers! Even if it has 50% growth, this company is not worth the investment – as the forward P/E (50)is much higher than the EPS growth (32%).

The reported EPS can be plain wrong. Unfortunately not many sites give the kind of information that investors need – like the end-period EPS, which is what I use.

You also need to do this analysis with all companies that have potential dilution – like Mindtree, FirstSource and the like. All these results will not consider end-period EPS.

Further, shares like Tata Steel will have tremendous dilution going forward, so consider that in future result announcements too.

  • sushanth says:

    >Deepak,

    Whats your opinion on rising rupee and its impact on exports esp the IT exports?
    I have been hearing lately that the rupee value might come down to 35, though its my opinion that RBI will intervene much before that happens.

    Do you what are these forward contracts these IT biggies buy?

    Thank you.

  • sushanth says:

    >Are looking into MIC electronics IPO?

  • Anonymous says:

    >boss.. if you dont understand finance, dont blog about it and make a fool of yourself. Thats the standard way EPS is accounted for. And there is a financial rationale for it as well. Pls speak to someone who understands this before blogging!

  • Deepak Shenoy says:

    >Anonymous: Probably you might want to explain how this makes sense to us as investors, please, since you’re more knowledgeable?

    A weighted average number of shares makes no financial sense, it only makes sense to prorate earnings to number of shares outstanding through the year. Even that is of no use to us as investors, since EPS growth will stagnate because of funny numbers.

    Thanks for your comment.

  • Deepak Shenoy says:

    >Sushant: Rising rupee is a problem, and the impact will be in the immediate next quarter. Don’t read news about this stuff – eveyrone will give you a different opinion.

    Hedging is a problem. Both Infy and TCS have only about a quarter’s worth of revenue hedged. So this quarter – APril to June 07 – things should be fine, but if the dollar stays below 42 after that, it’s cause for concern.

    I’m selling all the IT stocks I own – for other reasons, the dilution effect of their stock options in the face of mediocre guidance is troubling me.

    I’m not looking at MIC electronics – don’t have the time to analyse it at the moment.

  • Akshay J says:

    >In US, companies quote the basic and diluted EPS separately to prevent this sort of ambiguity.

    If such ambiguity can surprise seasoned investor like yourself, it is a tough call for most lay people.

    I however, do not find the argument that EPS going forward will necessary be poor. Occassionally, companies fail to grow because of capital crunch and IPOs such as this provide an opportunity to boost growth. This is a test of good management.

    While P/E and therefore EPS remains an important benchmark, along with many other considerations.

    As Peter Lynch said “With few exceptions, an extremely high P/E ratio is a handicap to a stock, in the same way that extra weight in the saddle is a handicap to a racehorse.”

    Personally, P/E remains an important benchmark for me (with many other considerations) – I am no expert on markets (actually, I figured nobody really is.., especially those suckers on CNBC), I consider today’s markets overpriced. The markets may very well hit 25000 on Sensex, by end of this FY, but I won’t join this party.

    There are many factors to consider:
    1. Interest rates are very high. Other than most cash rich companies, it will affect bottom line of many companies.

    2. Rupee may continue to strengthen, because RBI may not want to intervene, to avoid inflationary pressure (which is politically so wrong). This will impact IT companies. You can’t hedge indefinitely – eventually you must bring money home, which will further strengthen rupee.

  • Anonymous says:

    >I am in a dilemma, would like to seek your help on the same.
    I am into second year of my car loan, and i am in two minds on whether to pay it off or invest the same money into stocks which will eventually earn more than the monthly EMI.
    Would like to seek your opinion on this?

    Thank you

  • Kaushik says:

    >The “other income” effect seems to be widespread:

    http://www.livemint.com/2007/05/07235328/Other-income-makes-India-Inc.html

    “Almost a fourth of the net profit of Indian companies comes from other income, such as the sale of real estate, equity in subsidiaries, refund of income tax, and treasury operations that include currency and commodity trading.”

  • Deepak Shenoy says:

    >Akshay: Even in India we have to quote Diluted and Basic EPS, but both must take the weighted average of shares, unfortunately.

    What I meant about EPS going forward was – that in spite of a big earnings growth, the net EPS growth may not be much because of this accounting issue. You always pay a multiple of EPS, and that multiple is justified by EPS growth. So if EPS doesn’t grow much you stand to lose.

    You’re right – a high P/E is tough on performance. But good companies are priced high, that’s for sure. Still, a very high P/E and a serious EPS growth impact does not augur well for stocks.

    You are absolutely right in your concerns. The rupee and interest rate pressure will show, if it’s not already showing.

  • Deepak Shenoy says:

    >Anonymous: DON’T DO IT. Never take debt to invest in stocks if you are not a professional trader.

    Car loans are expensive, and paying them off may make more sense. I’m assuming you’re salaried and the loan repayment has no tax benefit.

  • Deepak Shenoy says:

    >Kaushik: Wow! man this must be something.

    I guess a sale of an asset would be an “extraordinary” item rather than pure “other income”. Interest or dividends would then be regular otjer income, I guess.