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 priceearnings (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
bookvalue 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
bookvalue 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 paidup capital.
Example: A company earns a profit after tax of
Rs. 10 million for the year ended 30th June 2001. Its paidup 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=Bookvalue per share multiply
by Return on shareholdersí equity.
The Bookvalue (or net asset value) per share shows
the amount of shareholders' equity attributable to each share.
Shareholders' equity comprises paidup 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, bookvalue 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 
Bookvalue 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 bookvalue, whereas the
reverse (low profitability and high bookvalue 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 bookvalue 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 bookvalue 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 19962000 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 = Bookvalue 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
bookvalue (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
bookvalue 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.