Importance of EPS in equity investing

If you look at long term performance of different mutual fund schemes, you will see that some schemes outperformed others in the same category by a big margin. In the short term, performance gap can be explained by market driven factors, which may favour some stocks or sectors over others. But performance gap, over a long period of time, can be attributed mainly to the process of stock selection and portfolio management. In this series of posts, we are discussing various aspects of stock selection and portfolio management techniques that fund managers may follow to deliver superior performance.

In the previous posts of this series, we have discussed the importance of return on Capital Employed in Equity Investing and how fund managers can use derivatives for portfolio hedging. In this post, we will discuss the importance of Earnings per Share or EPS in equity investing.

What is EPS?

In very simple terms, the earning per share or EPS of a company is the Net Profit or Profit after Tax (PAT) of the company divided by the total number of shares outstanding. Let us now understand this in more details.

What is Net Profit or PAT? From an accounting perspective, the PAT is the bottom-line of the P&L statement or the income statement. It is calculated by subtracting all expenses, including operating expenses, depreciation and amortization, interests and tax from the revenues of the company. From a conceptual standpoint, PAT is the money left at the end of the period (quarter, year, etc), for ploughing back into the company for future business growth and / or for distributing to shareholders of the company, either as dividends and / or through share buyback.

What are numbers of shares outstanding? Numbers of shares outstanding are the shares held by the promoters of the company, institutional and retail investors. The number of shares outstanding changes from time to time, with rights issues, bonus declaration, private placements, follow on public offer (FPO), issue of stock options to employees of the company, share buybacks etc.

Please note that, the definition of EPS given above is a simplistic one, so that our readers are able to understand the concept of EPS.

Why is EPS important?

EPS is a measure of the profitability of the company. Usually, higher the EPS of a company, higher is its share price. The absolute EPS of the company is less important than the EPS growth.

There are two kinds of EPS growths that analysts focus on, sequential growth (quarter on quarter growth) and year on year (YOY growth). Let us understand this with the help of an example. Let us suppose Company A, posted an EPS of र 50 in Q4, FY 2016. The company posted and EPS of र 45 in Q1, FY 2016. As per the latest earnings release of the company for Q1, FY 2017 the EPS is र 53. The sequential EPS growth of the company is 6% (र 53 versus र 50), whereas the YOY EPS growth is 18% (र 53 versus र 45).

We will discuss later, the merits and demerits of sequential versus YOY growth, but EPS growth by itself, is an important indicator of whether the shareholder will make money from his investment or not.

At the beginning of each quarter, analysts estimate the EPS growth of a company. If the EPS growth of the company in a quarter beats the consensus estimate of different analysts, the share price of the company usually rises. On the other hand, even if the EPS rises sequentially (QOQ) or on a YOY basis, but fails to meet the analyst expectations, the share price usually falls. There are multiple examples, where companies posted higher EPS (both sequentially and YOY), but the share price fell when earnings were declared.

Therefore, in addition to looking at the EPS growth of a company, investors should also look at the analyst estimates of the EPS. Some companies also give revenue and EPS guidance for coming quarters. Even if a company beats the analyst expectations in EPS growth, but the company gives a lower guidance for coming quarters, the share price can take a beating. At the end of the day, you have to remember the share price of a company is simply a reflection of the future free cash flow growth of the company.

Sequential versus YOY EPS growth

Let us now discuss whether you should look at sequential or YOY EPS growth. In a fast developing economy such as ours, a lot of importance is paid to sequential growth. This especially holds for companies in cyclical sectors, when the economy is going through a transition or recovery. However, sequential growth has its drawbacks because it does not take into account seasonality of revenues and earnings.

In a country like India, for white good manufacturers like Air Conditioners, refrigerators etc, Q1 is more profitable quarter than Q4 of the prior, simply due to weather conditions. Similarly, Q2 or Q3, whichever coincides with the festival season, is a more profitable quarter than the prior quarter, because lot of consumer durable purchases are made in the festive month.

Again for the FMCG sector, monsoon brings in seasonality in revenues and earnings, especially, as far as rural demand is concerned. YOY growth is not affected by seasonality. On the other hand, if a sector is going through some structural issues (e.g. the banking sector now, especially public sector banks), you will like to know, if the situation has improved or worsened in the last one quarter and in those cases QOQ growth is also important. YOY EPS growth is in general terms, a better measure of company’s performance trajectory, but one cannot ignore sequential growth.

What is more important, current EPS or future EPS?

Current EPS is important, but future EPS (or EPS growth) is even more important. Two EPS measures are used in to share price valuations:-

• Trailing Twelve Month (TTM) EPS or EPS of the last four quarters


• Forward EPS or EPS forecast of the next four quarters, including the current one

Analysts use Forward EPS more than TTM EPS in valuing a company through measures like the Price Earnings (P/E) Ratio. The TTM EPS, though a useful measure, is already baked into the share-price of the company. If the company has given great results and good returns, as a shareholder you have the option of booking profits or continue to hold the shares. If you continue to hold the shares, you should be interested in what the company will do in the future and therefore forward EPS is more important.

Does EPS growth result in a corresponding rise in share price?

A share price of a publicly traded company is a function of two variables, the EPS of the company and the valuation of the company. In a liquidity driven market such as ours in India, valuation is what matters more, in the short term.

What is valuation? The most common measure of valuation is P/E ratio. We will not go into an in depth discussion on P/E ratio in this post, but suffices to say for now that, P/E ratio is simple the ratio of the share price of the company and the EPS of the company. P/E ratio can either be forward or trailing twelve months (TTM), depending on whether one uses forward EPS or TTM EPS.

P/E ratio of a company depends on a variety of factors including the growth prospects of Indian economy in general, growth potential of the sector, risk sentiment and liquidity in the market. In a market like India, liquidity is an important consideration, because our market is dominated by Foreign Institutional Investors (FII). Very often, we see that the share prices and P/E ratios companies running far ahead than the EPS growth. But inevitably, we also see the same companies correcting sharply, when market conditions are not so favourable (we saw many such instances in FY 2016).

Therefore, for long term investors, EPS growth trajectory is an important factor, that they should always keep a watch on irrespective of share prices in the short term.

Quality of EPS

EPS growth trajectory is very important in equity investing; there can be no two words about it. However, how important is quarterly EPS? There is a criticism that, companies are now too focused on quarterly earnings, rather than delivering long term value to their shareholders. You may have heard, fund managers often saying that, “we look at the quality of EPS, not just at EPS growth”. What does “quality” mean? You have to understand that, EPS is more of an “accounting” concept relative to an “economic” concept. Fund managers try to understand, how the company delivered its EPS numbers.

A company can deliver high EPS, through one time income (like profit on sale of assets), through cost cutting (not that cost cutting is bad, unless the management is cutting on investments, which inevitably has a consequence on future EPS), through accounting shenanigans (how many times have we seen companies doing that!!) and through share buyback (which many a times tells you that the management does not have great ideas to deploy their cash reserves). The best type of EPS growth is through, high revenue growth, great operating leverage, while making investments for business growth at the same time.

Conclusion

The importance of EPS growth varies for a growth investor versus value investor. A growth investor pays more importance to EPS growth in the next 12 months, whereas a value investor is more focused on the long term growth potential of the company. EPS growth is important in equity investing. If you are investing in equities through mutual funds, try to understand how your fund manager uses EPS growth in investment strategy.