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Earning per share — A framework for analysis.

By ALTAF NOOR ALI, ACA
Oct 01 - 07, 2001

Investors and analysts consider "earning per share" (eps) as an important measure of financial performance. Eps is applied in computing price-earnings (P/e) ratio, also termed as "earnings multiple". The P/e ratio is reported and commented upon widely in the financial press.

Eps is a mandatory disclosure in the accounts of a listed company. The accounts (or financial statements) of a company comprises balance sheet, which shows its financial position, and income statement, which shows its financial performance, among others.

The eps figure is computed in accordance with International Accounting Standard 33. It is normally located at the end of the income statement (or Profit & Loss Account) and its computation is disclosed in the form of a note to the accounts.

The analysis of eps is carried out with alongwith other financial information. The prevailing practice is that no financial analysis is considered as complete without computation of book-value per share, return on shareholders' equity, sales per share and net profit margin, but these "benchmarks" are studied independently and in isolation, not as a framework that accurately accounts for change in eps.

In this article, we propose that our understanding of changes in eps can be enhanced considerably when eps is transformed to reflect financial position and financial performance of a company.

In short, eps needs to be seen as a product of book-value per share and return on shareholders' equity ratio, as these reflect changes in financial position. On the other hand, eps reflects changes in financial performance when viewed as a product of sales per share and net profit margin. Combined, the two elements of eps, like two sides of a coin, offer fresh insight into the financials of a company.

Basic form of eps:

In its most basic form, eps is computed by taking "profit after tax" and dividing it by number of shares issued as paid-up capital.

Example: A company earns a profit after tax of Rs. 10 million for the year ended 30th June 2001. Its paid-up capital throughout the year was 1 million ordinary shares of Rs. 10 each. The eps for the year 2001 is Rs. 10 (Rs. 10 million divided by 1 million).

Eps and "profit per share" refer to the same concept but note that the standard term is "earning per share" and not "profit per share". The term "earnings" is a broader concept than ëprofití or plain ëincomeí.

Illustration:

We will use the figures from annual reports of Fauji Fertilizer Company Limited, which is listed on all stock exchanges of the country, to demonstrate our approach.

 

1996

1997

1998

1999

2000

Sales (Rs.'000s)*

11,739,116

12,055,669

13,561,685

10,463,079

10,201,319

Profit after tax (Rs. '000)

2,453,709

3,370,201

3,759,858

3,087,276

2,643,913

Shareholders' equity (Rs.'000)

4,757,828

6,076,061

7,527,456

8,562,764

8,869,045

Number of shares ('000s)

256,496

256,496

256,496

256,496

256,496

Eps and financial position:

In its first form the eps can be expressed as follows-
Earning per share
Book value per share Return on Shareholders' equity

This simply means eps=Book-value per share multiply by Return on shareholdersí equity.

The Book-value (or net asset value) per share shows the amount of shareholders' equity attributable to each share. Shareholders' equity comprises paid-up capital and reserves.

Alternatively, shareholders' equity can also be seen as surplus of assets over liabilities (equity equals assets minus liabilities). In terms of net assets, book-value per share reflects the amount of assets attributable to each share.

The return on shareholders' equity (ROSE) is computed here with reference to shareholders' equity as on balance sheet date (dividends paid during the year or payable are ignored). Note that it is acceptable to compute ROSE on average balance of shareholders' equity, but not applicable for this approach.

The result of our solution are stated below-

 

Formula

Ref.

1996

1997

1998

1999

2000

Earning per share (Rs)

Profit after tax/ Number of shares

1=2*3

9.57

13.14

14.66

12.04

10.31

Book-value per share (Rs.)

Share capital and reserves / Number of shares #

2=1/3

18.55

23.69

29.35

33.38

34.58

Return on shareholders' equity

Profit after tax/Share capital and reserves #

3=1/2

0.5157

0.5547

0.4995

0.3605

0.2981

The return on shareholders equity is more conventionally expressed in terms of a percentage as 1996: 51.57%, 1997: 55.47% etc.
# Note that "Share capital and reserves" cancels itself out in 2 & 3 above and the result is eps.

Linking eps and financial position:

In case of Fauji Fertiliser we can see that its eps (of Rs. 10.31) for the year ended 2000 is near its eps for 1996 (Rs. 9.57). However the difference, visible by studying accompanying graph plotting all data together, is that the eps of 1996 is marked by high profitability (return on equity) and lower book-value, whereas the reverse (low profitability and high book-value per share) is true for 2000 ..and possibly beyond.

The essence of this relationship lies in its capability for derieving any unknown variable provided the other two are known. The target return on shareholders' equity can be found by taking estimated eps and dividing by book-value per share. This knowledge can be handy in performing "sensitivity analysis" based on estimates of any two financial indicators.

Just to demonstrate, if the target eps for Fauji for 2001 is Rs. 11 and the target book-value per share is Rs. 35.20, the return on shareholders' equity will be 31.25% (i.e. 11/35). A range of values can therefore be calculated with this relationship in place.

Eps and Financial Performance.

The eps, in its second form, can be expressed as follows-
Earning per share
Sales per share Net profit margin

The above simply means that eps= Sales per share
#Net profit margin.

The sales per share show the amount of sales attributable to each share. This ratio faithfully reflects the impact of increase in number of shares in a given year, which would otherwise remain concealed in terms of absolute numbers.

The Net profit margin relates the profit after tax to sales. To simplify, we only consider sales (the top line) and profit after tax (the bottom line) and exclude everything between the two.

The result of our solution are stated below-

 

Formula

Relation

1996

1997

1998

1999

2000

Eps (Rs.)

Profit after tax/Number of shares

1=2*3

9.57

13.14

14.66

12.04

10.31

Sales per share (Rs.)

Sales/Number of shares#

2=1/3

45.77

47.00

52.87

40.79

39.77

Net profit margin

Profit after tax/Sales#

3=1/2

0.2090

0.2796

0.2772

0.2951

0.2592

The Net profit margin can be expressed in terms of percentage as 1996: 20.90%, 1997: 27.96% etc.
#Note that "Sales" cancels itself out in the equation and the net result is eps.

Linking eps and financial performance:

The number of shares of Fauji Fertilizer did not change during 1996-2000 period. This accurately reflects the declining trend in sales per share. It appears that Fauji Fertilizer is finding it increasingly difficult to command a good price for its product. This is further confirmed by the observing a rising trend in its receivables.

The net profit margin of the company also appears to have reached its peak and is now under pressure.

The management of the Company have two ready tasks on hand: to improve sales and to sell it at a good price to protect its margins which surely is an uphill task given the local and international competitors.

Putting it all together:

To summarise, a meaningful analysis of eps is possible by linking it to financial position and financial performance, as follows-

Earning per share = Book-value per share multiply by Return on Shareholders' equity = Sales per share multiply by Net Profit Margin.

In other words, one angle of looking at eps is as a return on book-value (net assets) of a company per share; the other is to look at it as a return on sales per share.

In case of Fauji Fertiliser, the components of eps are summarised in a pallete form as follows-

 

Formula

Ref.

1996

1997

1998

1999

2000

Earning per share (Rs)

Profit after tax / Number of shares

1=2*3
& 4*5

9.57

13.14

14.66

12.03

10.31

Book value per share (Rs.)

Net assets / Number of shares

2=1/3

18.55

23.69

29.35

33.38

34.58

Return on shareholders' equity

Profit after tax / Net assets

3=1/2

0.5157

0.5547

0.4995

0.3605

0.2981

Sales per share (Rs.)

Sales / Number of shares

4=1/5

45.77

47.00

52.87

40.79

39.77

Net profit margin

Profit after tax / Sales

5=1/4

0.2090

0.2796

0.2772

0.2951

0.2592

The minor difference in above computations is because of rounding.

Conclusion:

The strength of foregoing approach is the way it integrates four important financial benchmarks in a framework. Integrating these benchmarks in a framework provide a tool for gaining useful insight for financial analysis of eps. Our approach minimises the chances of computational errors and enhances the quality and understanding of financial analysis.

Examining eps figure, in pairs, as a product of book-value per share and return on shareholders' equity, and as a product of sales per share and net profit margin, reveals clearly the reason for its change.