EPS and PE Calculations Wyman,

¶ … EPS and PE calculations

Wyman, Rick. (2009). How to evaluate the quality of EPS. Retrieved September 30, 2009

through Investopedia at http://www.investopedia.com/articles/analyst/03/091703.asp

Rick Wyman, the author of "How to evaluate the quality of EPS" cautions the careful investor to be wary of taking EPS (earnings per share) and P/E (price-to-earnings) ratio calculations at face value. Theoretically, even a relatively "high-quality" EPS that strives to give a reasonably true representation of what the company actually earned is invariably biased by some degree of accounting smoke and mirrors, while "low-quality" EPS earnings that actually misrepresent a company's financial status are far from uncommon (Wyman 2009). Companies may comply with the letter of the law, yet still present an inaccurate picture of the sources of their revenue to investors. Many investors take statements at face value, and have little understanding of how the rosy figures are calculated.

Wyman advocates evaluating EPS in light of a company's operating cash flow per share. But the ability to compare operating cash flow per share to reported EPS can be compromised by the fact that the necessary information is not required to be released until "months after results are announced" when the company files its 10-K or 10-Q with the Securities and Exchange Commission (SEC) (Wyman 2009). The purpose of Wyman's article is to advise investors, not propose changes to existing regulations. However, requiring more frequent reporting of actual operating cash flow as a method of empowering investor knowledge might be an intriguing suggestion, and one to explore in a future article.

Wyman wisely counsels the reader that "cash is king" (Wyman 2009). This is something that even savvy investors failed to heed before the credit crisis of 2007. One of the reasons for the crisis was a lack of transparency. Companies seemed to be extremely profitable, even though most of their earnings were based upon borrowing, rather than actual, debt-free earnings. Never forget that a company can have an income statement that is in the black on paper while still "bearing a negative cash flow" (Wyman 2009). Reading between the lines, an investor should be cautious. If a company must borrow money for its basic operations, this is a red flag. Borrowing for a long period of time may be an indication that the company's future is in jeopardy.

Borrowing -- from a bank or from the federal government, selling stock to the public, or selling off assets are all ways to make a balance statement look positive, even when a company is actually losing money. Wyman makes an example of a fictional company to illustrate his point for simplicity's sake. Say that a company had an ethically reported EPS of one dollar, and the company's growth rate was 20%. "In most markets, investors would buy this stock" (Wyman 2009). But Wyman would look at the operating cash flow per share. If the company had undertaken some of the 'smoke and mirrors' measures listed by Wyman to make itself look better on paper, such borrowing, selling more shares to the public than ever before, or engaging in a 'fire sale' of assets, and the actual operating cash flow per share was a negative $0.50, this "would indicate that the company really lost $0.50 of cash per share vs. The reported $1.00" (Wyman 2009).

A company could very easily show a positive EPS because of a one-off sale of an unprofitable venture. But if the company did not change its poor management policy, or was in a poorly-performing sector of the economy, this would not bode well for investors in the coming years. Thus, industry trends are another potential guideline for investors. Even if a company posts a strong showing one year, this is no guarantee that the trend upward will continue, if it is located in a potential 'black hole' of the economy. For example, a luxury company might sell off a division of its holdings, and post strong earnings, but if its core operations were showing a loss, this would be even more troubling for investors than if the company was part of a healthier sector of the economy. A luxury business many not flourish in the current cautious and pessimist economic environment.

Wyman does not use a specific, real-world example to illustrate his points. This is one critical weakness of his article, given that there are so many real-world examples of companies that have borrowed too much to show inflated earnings, or companies that are using borrowed funds or funds earned from selling off critical assets to boost their apparent earnings. Wyman also only includes a cursory discussion of how price to earnings (P/E) as an estimated forecasted are useful when deciding to invest in a company.