Can you trust a company's 'reported EPS'? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Can you trust a company's 'reported EPS'? 

A  A  A
In this issue:
» An extreme step proposed by a mystery shareholder!
» PSU banks crack down on middlemen
» Royalty payments back on government's radar
» Why inflation may start rising in the US soon....
» ...and more!

The share markets in India have witnessed more than its fair share of scams and scandals. Many a time promoters have been right at the center of them. From insider trading to outright accounting fraud, we have seen it all. This might lead some people to believe that scams related to the markets can only be something that are large in scale. We certainly do not subscribe to this view. Smaller financial shenanigans are quite common. Mostly the phrase, 'the devil lies in the detail' is quite an appropriate one we believe.

A few days back, market regulator SEBI, slapped a fine of Rs 130 m on Reliance industries for allegedly misleading investors regarding the company's 'Diluted EPS'. Whatever the facts of this particular case might be, we believe that investors should be aware of the importance of the core issue of 'per share earnings'. This is important because ultimately, the company's profits belong to all its shareholders. Thus, the sanctity of the reported per-share profit is crucial. Consider this simple example. If a company reports a net profit of Rs 1000 m and it has 10 m shares outstanding then the reported basic earnings per share (basic EPS) will be 100 (i.e. 1000/10). This is simple enough in theory but in practice, things can get murky. EPS is a number that can be easily tampered with.

Warrants issued to promoters and stock options issued to top employees, opens the door for the increase in share capital. Thus in the example above, if 1 m shares are issued as options/warrants, then there is a potential for the number of shares to increase, as and when they are exercised. This is where the 'Diluted EPS' comes in. The diluted EPS is calculated by factoring in the all the shares that can dilute the earnings, due to the increase in the share capital. Thus in our example above, the diluted EPS will be 90.9 (i.e. 1000/11). While the difference in basic and diluted EPS might appear small, in reality, it makes a big difference. The reason is that over a period of time, the dilution can result in a huge loss of value.

Long term investors, should be vigilant about the number of shares that can be issued when calculating EPS. The market regulator certainly understands its importance. The per share earnings is often the basis for valuing a company. Even if a company is growing its profits, the growth in EPS may be muted due to the share dilution. Thus investors must take a call if the earnings growth can be sustained. If not then it would be a poor idea to invest your money in such a stock. It is not a good idea to accept the reported EPS at face value. We believe that a business should be valued after assuming the full possible dilution. We have explained this concept and its impact on valuations in our 'Back to Basics' series. This idea might seem conservative but it can make the difference between a great investment and a poor one.

Do you factor in share dilution while evaluating a stock? Let us know in the Equitymaster Club or share your comments below.

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02:10  Chart of the day
One of the key reasons for subdued trend in markets for most part of 2013 was the volatility and slowing growth rate in earnings. However, with the Modi government having come in, high expectations have been built in - as can be seen from the way the markets have performed in recent times. In short, it is expected that there will be a substantial improvement in corporate India's financial performance going forward.

But from what it seems India Inc. is off to a good start! As per the Economic Times, a sample of a thousand companies - excluding those from the bank stocks, finance and oil & gas sector - that have announced their numbers for the quarter ended June 2014 shows a very positive trend. While revenues are up by 15% YoY, operating margins were at their highest in three years. Further, profit growth during the quarter stood at a very high rate of 35% YoY. What has also helped in boosting the latter is the higher other income.

However, the question here is how sustainable this growth rate would be considering that the sentiments have largely driven the overall bounce back in business activity of late. Nevertheless, taking the example of the Sensex's earnings where growth rates declined to as low as 10% levels a few quarter ago, one can definitely expect an improving trend.

Stable and robust topline performance

If you think you've had your fill of investor activism in recent times, you could well be wrong. There is another interesting case that has come to light recently. As per a leading daily, the split in the Indiabulls group, one of the fastest growing Indian conglomerates, could well have been a forced one instead of being voluntary. There's a strong reason why it is being felt this way. It so happened that just a few days before the split was announced, the group is believed to have received a letter from a mystery shareholder. Apparently, the mystery shareholder or shareholders had proposed a resolution in the letter. And it called for removal of two promoters and three independent directors from the board of Indiabulls Housing Finance. It is interesting to note that Indiabulls Housing Finance is the most valuable company in the entire Indiabulls group. Now, a resolution seeking to remove directors from the board is extremely rare. And therefore it does raise a question of what possibly could have led to this extreme step. Were these shareholders in any way aware of something that was not quite appropriate? Well, the group does have a history of not quite getting top marks when it comes to corporate governance practices. Therefore, the sooner it comes out clean on this issue, the better it will be for the group's image we reckon.

The recent arrest of the Chairman of Syndicate Bank in bribe negotiation case may have been just the tip of the iceberg. The performance of PSU banks over the last few years has hardly been encouraging; to say the least. And poor economic performance is not entirely to blame! The impact of lending practices in PSU banks is for everyone to see. The RBI has been citing its displeasure with the NPA crisis for a while. However, this is the first time that the chief of a bank has been implicated for involvement in corrupt lending. It seems the middlemen who broker the deal between big corporate borrowers and banks are equally guilty. Therefore to arrest such instances, PSU banks are now cracking down on the middlemen culture as well. As per Economic Times, PSUs like Indian Bank and Andhra Bank have already barred such middlemen from entering their premises including branches. And SBI is fortifying its due diligence process to avoid improper facilitation of loans or loan extensions. These may help PSU banks rid themselves of the corrupt practices for the time being. However, the banks need to have autonomy and adapt more technology and transparent systems to keep a close watch on their asset quality.

Royalty income is a nice cushion for companies that float overseas subsidiaries. Being a steady source of income, royalties also provide a nice buffer during poor times. However, it seems that these foreign firms are trying to feast on the royalty largesse. That too without considering the financial health of their Indian subsidiaries. As per an article in Live Mint, the 25 highest royalty paying companies saw a 24% growth in royalty payments in 2013. However, their sales and profitability growth stood at 15% and 13.1% respectively.

Higher royalty payments not backed by improved performance from subsidiaries has raised eyebrows. There is a lingering feeling that foreign firms are extracting money via this mode. As such, the issue is now on the government's radar. It may be noted that until 2009 there were limits on remitting money to foreign companies via royalties. And the new government is contemplating imposing them.

Nothing concrete has been decided over it as yet. But the fact that foreign firms are sucking out cash via this mode has made government circumspect. A cap could dampen investor confidence. However, what matters more is minority shareholders' interest. If foreign firms are drawing out cash in the name of royalty, the government should consider imposing cap we reckon.

If recent statistics are anything to go by, the US economy seems to have taken a turn for the better. In the previous quarter, US economy witnessed low productivity and high labor costs. So much so that the unit labor costs rose up by 11.8%. However, this quarter has brought some relief. Now that the economy is past cold winter season, it has witnessed better productivity this quarter. With low labor costs, some believe that the concerns of inflation in the near term have been allayed. Higher productivity is likely to support better wages without putting pressure on inflation or profits of the company.

However, the momentum is more likely to slow down than sustain as far as productivity is concerned. The current increase of 2.5% annual rate for this quarter follows a sharp decline in the preceding quarter. In the last three years, it has never been above 1 % on an annual basis. In short, it may not take long for rising labor cost to put pressure on bottomline. Higher production costs could lead to inflationary pressure and less room for the Fed to keep interest rates low. And such developments will have serious repercussions for other economies including India as they will determine the foreign capital flows in the country.

The Indian stock markets continued to trade higher in the afternoon trading session. At the time of writing, the BSE-Sensex was trading up by 201 points (+0.8%). Barring FMCG and power, all the sectoral indices were trading in the green. Auto and realty stocks were witnessing maximum buying interest. Most of the Asian markets were trading firm led by Japan and China. Even European markets have opened the day on a strong footing.

04:55  Today's investing mantra
"We want to be right on something that will work right now, not something that might work in the future." - Warren Buffett
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2 Responses to "Can you trust a company's 'reported EPS'?"


Aug 19, 2014

The article is very elaborate and explains the importance of EPS disclosure. It came to me at very right point when I wanted to read more on this topic.. as after reading various quarterly results and observing 2 EPS disclosures (which often are similar values) this comes as great learning

Thanks for nice article.


Ratnakar Shetty

Aug 11, 2014

Instead of cap on royalty, govt should charge a differential rate of income tax. For any royalty in excess of 1% of turnover, govt should charge a penal rate of income tax say 60% or 70%. This will automatically deter foreign companies from increasing royalty

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