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A love affair with EPS

Jul 13, 2009

It is no secret that the earnings a company is able to achieve in a particular year or quarter holds a special place in the hearts of most participants in the stock market. Predicting next quarter's earnings for a company is one of the hottest topics of discussion (or more aptly - speculation) on 'business' channels. And if the earnings turn out to be not in line with those 'estimates'... boom! The stock gets a beating on the day of the earnings announcement. This extreme fixation on the most recent earnings per share (EPS) of a company, at the cost of ignoring many other aspects of sound evaluation of a business, can be very dangerous to say the least. As Benjamin Graham once expounded, there are many pitfalls to relying solely on the company's current earnings performance to decide whether or not it is worth investing in. Some of them are as follows -

  1. Instead of the double test of value provided by evaluating both the earnings and the assets of a company, one would be relying upon a single and therefore less dependable criterion. Even though earnings are important and have their own rightful place, a company's resources still have some significance and require attention.

  2. Second, these earnings statements, on which exclusive reliance has come to be placed, are subject to more rapid and drastic changes from time to time. Much more than those which occur in balance sheets. Due to this, a much higher degree of instability and volatility is introduced into the valuation of stocks. This is painfully evident in the way prices of stocks can change drastically from year to year, or even from day to day, even though actual changes to a business would take much longer and be much more gradual.

  3. Third, the income statements can be much more vulnerable to misleading presentation and mistaken interpretation than is a balance sheet. For example, big changes in extraordinary income or other income whose source is other than from that of the core business of the company can bring in added complexity to the final EPS figure of the company. Thus, many a times giving out a distorted picture of the earnings power of the company. More often than not, this and many other such subtleties go unnoticed. What stands out most prominently is the final EPS figure and its change from the previous year. And that's what ends up having an immediate and strong effect on the price of the stock.

If you are were the owner of a private business, you would surely not decide the worth of your business solely on the basis of its most recent operating results, without giving any attention to the resources the business commands (its assets). But that attitude, for some unwarranted reason, changes when one lays down his own business' statement, and picks up that of a listed company. By paying excessive attention to earnings and conversely, no attention whatsoever to the balance sheets, one exposes oneself to all the perils discussed above.

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