7.5 EPS as a Performance Indicator: Trends and Limitations

7.5 EPS as a Performance Indicator: Trends and Limitations

Where this sits in the syllabus: Section 6.4 of this guide showed you how to calculate basic and diluted EPS under IAS 33, and section 7.3 placed EPS among the investor ratios. The FR syllabus has a third, separate outcome in the limitations of interpretation techniques area: explain why the trend of EPS may be a more accurate indicator of performance than a company's profit trend, explain the importance of EPS as a stock market indicator, and discuss the limitations of using EPS as a performance measure. That is discussion-mark territory in Section C, and it is the part candidates most often skip.

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1. Why the EPS Trend Beats the Profit Trend

Profit is an absolute number. It can be increased simply by deploying more capital — and if that capital comes from issuing new shares, the existing shareholders may be no better off at all.

                 THE PROBLEM WITH A PROFIT TREND

   Year 1:  Profit $10.0m   |   4.0m shares   |   EPS  $2.50
   Year 2:  Profit $12.5m   |   6.0m shares   |   EPS  $2.08
            +25% PROFIT     |   +50% SHARES   |   -17% EPS

   The headline reads "profit up 25%".
   The shareholder's actual return per share has FALLEN by 17%.

EPS solves this by expressing earnings per unit of ownership. It answers the question the existing shareholder actually cares about: what did my slice of the company earn this year compared with last year? A rising profit trend accompanied by a falling EPS trend is the classic signature of growth funded by dilution — an acquisition paid for in shares, a rights issue used to buy a business that earns less than the existing operations, or a placing used to plug a funding gap.

IAS 33 reinforces this by requiring the weighted average number of shares to be adjusted for the bonus element in bonus issues and rights issues, and by requiring comparative EPS figures to be restated for bonus and rights issues. That restatement is what makes the EPS series genuinely comparable over time, and it is the reason the EPS trend is a defensible analytical tool where a raw profit trend is not.

[!TIP] A clean Section C sentence. "Although profit after tax increased by 25%, EPS fell from $2.50 to $2.08 because the share count rose by 50% to fund the acquisition. From the perspective of an existing shareholder the group's performance has deteriorated, not improved, and the acquisition has so far been earnings-dilutive."

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2. Why EPS Matters as a Stock Market Indicator

EPS is the bridge between the financial statements and the share price, because it is the denominator of the price/earnings ratio:

                   Market price per share
      P/E ratio = -------------------------
                   Earnings per share

Three consequences follow:

• EPS drives valuation arithmetic. If the market applies a stable P/E multiple, a change in EPS translates almost mechanically into a change in market capitalisation. A company on a P/E of 15 that raises EPS by 10 cents adds $1.50 to its theoretical share price.
• EPS expectations move prices more than EPS itself. Listed companies are valued on expected future EPS. Missing a forecast EPS by a small margin can produce a disproportionate share price fall, which is precisely why management has an incentive to manage the number.
• EPS is standardised enough to be quoted everywhere. Because IAS 33 prescribes the calculation, EPS appears on the face of the statement of profit or loss for entities with publicly traded ordinary shares, making it the one performance measure an investor can find without reading the notes.

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3. The Limitations of EPS as a Performance Measure

Diluted EPS as a Forward-Looking Warning

Diluted EPS restates the measure on the assumption that all dilutive potential ordinary shares — convertible debt, convertible preference shares, share options and warrants — have converted into ordinary shares. Its analytical value lies in the gap between basic and diluted EPS:

• A narrow gap tells a shareholder that existing earnings per share are broadly secure.
• A wide gap is a warning that the current basic EPS overstates the sustainable return per share, because the earnings pool is about to be shared among many more shares.

[!WARNING] Dilutive means dilutive. Potential ordinary shares are included in diluted EPS only if their conversion would decrease earnings per share from continuing operations. Anti-dilutive instruments are excluded. A candidate who mechanically adds every option and convertible to the denominator will get the wrong figure and the wrong conclusion.

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4. Worked Example: Profit Up, Shareholders Worse Off

Scenario

Fellside plc reports the following for the years ended 31 December 20X5 and 20X6.

                                              20X5            20X6
  Profit attributable to ordinary
     equity holders                       $10,000,000     $12,500,000
  Ordinary shares in issue at 1 January     4,000,000       4,000,000
  Shares issued at full market price
     on 1 January 20X6 to acquire Ravenstor Co       -       2,000,000
  Ordinary shares in issue at 31 December    4,000,000       6,000,000
  Market price per share at 31 December         $30.00          $26.00
  Convertible loan notes outstanding
     throughout 20X6, convertible into                        800,000
     new ordinary shares, post-tax                            shares
     interest saving on conversion                            $560,000

Step 1: Basic EPS

20X5:  $10,000,000 / 4,000,000 shares = $2.50
20X6:  $12,500,000 / 6,000,000 shares = $2.08   (shares issued on the first day of the year,
                                                  so no weighting adjustment is required)

Profit rose 25%; basic EPS fell 17%.

Note that because the new shares were issued at full market price, there is no bonus element, so the 20X5 comparative EPS is not restated. Had this been a bonus issue or a rights issue, the prior-year figure would have been restated and the comparison would have looked different again.

Step 2: Diluted EPS for 20X6

Adjusted earnings:   $12,500,000 + $560,000 post-tax interest saved  = $13,060,000
Adjusted shares:      6,000,000 + 800,000 potential shares           =  6,800,000
Diluted EPS:         $13,060,000 / 6,800,000                          =     $1.92

Dilution test: $560,000 / 800,000 = $0.70 of incremental earnings per incremental
share, which is BELOW basic EPS of $2.08, so the loan notes ARE dilutive and
must be included.

Step 3: P/E ratios

20X5:  $30.00 / $2.50 = 12.0 times
20X6:  $26.00 / $2.08 = 12.5 times

Step 4: The analytical verdict

• The profit trend is misleading. A 25% rise in profit was funded by a 50% rise in the share count. On a per-share basis the existing shareholders are 17% worse off, so the acquisition of Ravenstor has been earnings-dilutive in its first year.
• The market has not been fooled. The share price fell from $30.00 to $26.00, a fall of 13%, closely tracking the fall in EPS. The P/E multiple is essentially unchanged at 12 to 12.5 times, which suggests the market has repriced the shares for lower earnings per share rather than downgrading its view of the business's quality.
• Diluted EPS signals further pressure. At $1.92 against basic EPS of $2.08, conversion of the loan notes would reduce earnings per share by a further 8%. An investor assessing sustainable returns should anchor on the diluted figure.
• The limitations still bite. None of these figures reveals whether the acquisition will generate synergies from 20X7 onwards, what cash the enlarged group generates, or how the group's risk profile has changed. EPS analysis is a starting point for questions, not a conclusion.

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5. Common Exam Traps

[!WARNING] Trap 1: Comparing EPS between two companies. Every "calculate and comment" question that gives you two entities is testing whether you know that EPS is not comparable across companies because of differing nominal share values and accounting policies. Compare P/E ratios instead, and comment on each company's own EPS trend.

[!WARNING] Trap 2: Describing a rising EPS as unambiguously good news. Ask first how it rose. A share buy-back, a disposal gain, a change in accounting estimate or a reduction in the tax charge all raise EPS without any improvement in trading.

[!WARNING] Trap 3: Forgetting to restate comparatives after a bonus or rights issue. Comparing an unrestated prior-year EPS with a current-year figure computed on a larger share base produces an artificial decline and an incorrect commentary.

[!TIP] Structure every EPS comment in three moves. State the movement, explain the cause by reference to the numerator and the denominator separately, then state the limitation that qualifies your conclusion. That structure earns the calculation mark, the explanation mark and the evaluation mark in one paragraph.