Investing: Analyzing EPS
Earnings Per Share (EPS) refers to net income (profit after tax) divided by outstanding shares. Appearing on income statements, it shows us the earnings of the company after all expenses have been paid off and adjustments made for all depreciation of assets. As a result of accounting gimmicks, the earnings of a company can be easily manipulated. Therefore, if an investor just focuses on EPS, he may misread the value of a stock and end up making bad investment decisions. However, it will be much harder to manipulate the cash flow statement even tough it can still be done. High quality EPS refers to earnings that are a relatively true representation of what a company actually earns. Increasingly, cash EPS is being used to evaluate earnings. Also known as operating cash flow per share, it gives us the net effect of the inflow and outflow of money in a company's day to day operation. A cash flow statement breaks down cash flow into operation, investing and financing. A good company will normally display a growing trend of higher cash EPS against EPS. Cash EPS measures the net operating cash flow of a company on a per share basis. A higher cash EPS implies that the business is getting more inflows than outflows. Even tough getting more cash inflows doesn't necessarily mean that the business is making a lot of profit, basically, if a company is consistently getting excess operating cash flow, the business is surely generating extra cash from its sales after deducting all required payments related to the sales. The excess cash can be used to buy new assets, repay shareholders in the form of dividends or reduce outstanding bank borrowings. Investors need to be extra careful when a company's EPS is positive but has negative cash EPS. A negative cash EPS means the company has more operating cash outflows than inflows. It also implies that the company may have high inventory that isn't selling or receivables that aren't being collected. This requires extra financing either from shareholders' money or banker's loans. If this situation persists for a long period, shareholders or bankers may stop financing and want to be repaid. Conversely, if a company has negative EPS but has positive cash EPS, investors need not be too worried about the losses incurred. Certain financial experts also define cash EPS as 'EPS plus all non cash items' like amortization and depreciation. Even though a company's income can be affected by depreciation, amortization and other non-cash exceptional items, it can still generate positive cash flow from operations. If the company has zero borrowings, the extra cash flow can be used to reward shareholders with higher dividend payments. It will be good of can compare a company's cash with its own historical trend or those of other companies. Due to the cyclical nature of certain industries, investors shouldn't be too worried about a temporary negative cash EPS when the whole industry is on a downtrend. Investors will have a better picture of a company's performance when they analyze the difference between the trend of cash EPS and EPS. If a company's EPS and cash EPS are growing higher and cash EPS is always higher than EPS in most periods, this shows high quality in EPS. Cash EPS is a powerful tool to use in determining the quality of a company's earnings. Companies with a growing stream of cash EPS are better investments than those with higher EPS growth but negative cash EPS. Investors may be rewarded with higher dividend payments from the excess cash. However, if cash EPS is always lower than EPS, investors need to investigate whether it's only temporary or due to high trade receivables, which may later result in high bad debts. Michael Russell Your Independent guide to Investing |
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