In this research report on why there has a greater of emphasis on Earning Per Share or Share Holders Wealth Maximisation in the past ten years, I have tried to explain that what is E.P.S and Share Holders Wealth, Share Holders Value creation and Its standards. I have also written about the scenario which acted as catalyst in changing Managers mindset towards its Shareholders. This report also tries to bring the Importance of creating Shareholders and about its effect on the Investments in any company. I have discussed the entire topic in the light of changes in U.S. economic condition.
The termearnings per share (EPS)represents the fraction of a company's earnings, net of taxes and preferred stock dividends, that is allocated to each share of common stock. The figure can be calculated simply by dividing net income earned in a given reporting period (usually quarterly or annually) by the total number of shares outstanding during the same term. Because the number of shares outstanding can vary, a weighted average is typically used.
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EPS is a carefully scrutinized metric that is often used as a barometer to gauge a company's prosperity per unit of shareholder ownership. As such, EPS is a key driver of share prices. It is also used as the denominator in the frequently cited P/E ratio.
EPS can be calculated via two different methods: basic and fully diluted. Fully diluted EPS -- which factors in the potentially dilutive effects of warrants, stock options, and securities convertible into common stock -- is generally viewed as a more accurate measure and is more commonly cited.
Earnings per Share(abbreviated toEPS) is the amount ofprofitput aside by a company for each outstanding share ofcommon stock. It is simply a ratio that measures a company'searnings(profit after tax) divided by the number of ordinary shares. This can be used to measure a company's profit performance over time. It also shows the potential for paying outdividendstoshareholders.
Earnings per share can be easily calculated with the following formula:
Earnings per Share = net profit after tax / number of ordinary shares.
Earnings per share is relatively meaningless if analyzed on its own, although the higher the result the better for shareholders themselves. Meaning can only be established by comparing the previous year's results, to see how the company has developed.
What is often ignored when using the earnings per share ratio is the amount of primaryinvestmentneeded to pull in thenet incomelisted in the calculation. For example several businesses might end up with the same earnings per share amount, but company A might reach the number using less initial funds than the other companies. This suggests that company A is a more efficient business and therefore more stable and safer to invest in.
There are several types of EPS number used in analysis. These include:
- Trailing EPS - which is the previous year's number and is often compared with the current EPS
- Current EPS - is this year's number.
- Forward EPS - is a forecast of what the number might be in the future.
Different Kinds of EPS
Keeping track of quarterly Earnings Per Share figures and the percentage changes, along with P/E ratio (multiple) is often the bread and butter of stock evaluation. It is important to know the different types of EPS that companies report and how to put them in the correct context. By definition,EPS is net income divided by the number of shares outstanding. However, both the numerator and denominator can change depending on how you define "earnings" and "shares outstanding".
- Primary EPSis calculated using the number of shares that have been issued and held by investors. These are the shares that are currently in the market and can be traded.
- Calculation of theDiluted EPSaccounts for the shares that are currently in the marketplusthe extra shares that would enter the market is all exercisable warrants, options were converted into shares, hencedilutingthe ownership of current shareholders.
- Reported EPSorGAAP EPS, which are derived using the Generally Accepted Accounting Principles. This value can be distorted if corporate management wants to make the EPS look high. For instance, a one-time gain from the sale of machinery or a subsidiary could be considered as operating income under GAAP and cause EPS to spike. Alternatively, a company could classify a large lump of normal operating expenses as an "unusual charge" which can boost EPS because the "unusual charge" is excluded from calculations. In both these scenarios, the EPS value is being artificially boosted by non-recurring benefits, just to make the stock look particularly attractive this quarter (or year).
- Ongoing/Pro-Forma EPS
- Headline EPS
Always on Time
Marked to Standard
Calculated by using thenormalized income, i.e finding the earnings stream from core operations that are recurring and excluding unusual, potentially one-time income / expenses. For example, while evaluating Apple the investor should focus on income from the core operations, i.e their products and services. If Apple had an additional $600 Million income through a litigation in their favor, it should not be considered as recurring income. Similarly, the investor should be cautious of companies dismissing some expenses as "one time" or "unusual"
The EPS number that is highlighted in the company's press release and picked up in the media. Sometimes it is the pro forma number, but it could also be an EPS number that has been calculated by the analyst/pundit that is discussing the company. Generally, soundbites do not provide enough information to determine which EPS number is being used and often times it is simply the highest one that is stated publicly.
Caveats / Points to Remember
It is good practice to use Diluted and Normalized (Ongoing / Pro-Forma EPS) figures in your valuation. You could even calculateNet Operating Income per share, orEBITDA per shareand compare with previous years / quarters. Always use diluted though, warrants and options will be converted by owners if it is profitable to do so.
Beware of "Tax benefits due to employee stock options" and other such non-recurring tax deductions. A way around this is to calculateNet Income Before Tax per share.
You should always compare earnings growth relative to previous years / quarters. Steady increases in earnings per share is a good indicator of genuine growth and reduces the possibility that the company just had one great quarter which might not be sustained in the future.
According to Ben Graham, you should read the company's financial reports backwards since they will usually hide what they dont want you to see in the end. This also means that you cant always take the exact figures from Google or Yahoo Finance, because those don't exclude income/benefits that are potentially one time.
Shareholders Value Creation
Creating shareholder value is the key to success in today's marketplace. There is increasing pressure on corporate executives to measure, manage and report the creation of shareholder value on a regular basis. In the emerging field of shareholder value analysis, various measures have been developed that claim to quantify the creation of shareholder value and wealth.
More than ever, corporate executives are under increasing pressure to demonstrate on a regular basis that they are creating shareholder value. This pressure has led to an emergence of a variety of measures that claim to quantify value-creating performance.
Creating value for shareholders is now a widely accepted corporate objective. The interest in value creation has been stimulated by several developments.
- Capital markets are becoming increasingly global. Investors can readily shift investments to higher yielding, often foreign, opportunities.
- Institutional investors, which traditionally were passive investors, have begun exerting influence on corporate managements to create value for shareholders.
- Corporate governance is shifting, with owners now demanding accountability from corporate executives. Manifestations of the increased assertiveness of shareholders include the necessity for executives to justify their compensation levels, and well-publicized lists of under performing companies and overpaid executives.
- Business press is emphasizing shareholder value creation in performance rating exercises.
- Greater attention is being paid to link top management compensation to shareholder returns.
Defining Shareholder Value, and - Wealth Creation
From the economist's viewpoint, value is created when management generates revenues over and above the economic costs to generate these revenues. Costs come from four sources: employee wages and benefits; material, supplies, and economic depreciation of physical assets; taxes; and the opportunity cost of using the capital.
Under this value-based view, value is only created when revenues exceed all costs including a capital charge. This value accrues mostly to shareholders because they are the residual owners of the firm.
Shareholders expect management to generate value over and above the costs of resources consumed, including the cost of using capital. If suppliers of capital do not receive a fair return to compensate them for the risk they are taking, they will withdraw their capital in search of better returns, since value will be lost. A company that is destroying value will always struggle to attract further capital to finance expansion since it will be hamstrung by a share price that stands at a discount to the underlying value of its assets and by higher interest rates on debt or bank loans demanded by creditors.
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Wealth creation refers to changes in the wealth of shareholders on a periodic (annual) basis. Applicable to exchange-listed firms, changes in shareholder wealth are inferred mostly from changes in stock prices, dividends paid, and equity raised during the period. Since stock prices reflect investor expectations about future cash flows, creating wealth for shareholders requires that the firm undertake investment decisions that have a positive net present value (NPV).
Although used interchangeably, there is a subtle difference between value creation and wealth creation. The value perspective is based on measuring value directly from accounting-based information with some adjustments, while the wealth perspective relies mainly on stock market information. For a publicly traded firm these two concepts are identical when (i) management provides all pertinent information to capital markets, and (ii) the markets believe and have confidence in management.
The Importance of the Shareholder Wealth Maximization Standards
First, the duty of directors is not solely to make money for the shareholders, but rather to do so within the bounds of law. Second, it should be apparent that the duty of directors is not so much to make money as it is to maximize share value. The two are different, because the value of a share of stock is the present discounted value of the stream of dividends the stock will pay in the future. Hence, directorial actions that are inconsistent with short term profit maximization but are consistent with increasing the present discounted value of the future stream of dividends are perfectly appropriate. Suppose, for example, that Nestle management thought confusion over the national origin of its products might endanger employees working in predominately Muslim countries. If so, it would seem both ethical (preservation of life) and profitable (enhanced employee morale) to safeguard the lives and property of those employees through statements such as the ones about which Mark complains.
Shareholder wealth maximization provides a clear answer -- close the plant. Once the directors are allowed to deviate from shareholder wealth maximization, however, they must inevitably turn to indeterminate balancing standards. Such standards deprive directors of the critical ability to determine ex ante whether their behavior comports with the law's demands, raising the transaction costs of corporate governance.
Worse yet, absent the clear standard provided by the shareholder wealth maximization norm, the board of directors will be tempted to allow their personal self-interest to dominate their decision making. Put another way, directors who are allowed to consider everybody's interests end up being accountable to no one.
In the plant closing example, if the board's interests favor keeping the plant open, we can expect the board to at least lean in that direction. The plant likely will stay open, with the decision being justified by reference to the impact of a closing on the plant's workers and the local community. In contrast, if the board of directors' interests are served by closing the plant, the plant will likely close, with the decision being justified by concern for the firm's shareholders, creditors, and other benefited constituencies.
In sum, if you don't like corporate cowardice, the answer is to work for changes that make corporate courage profitable. If you thought Nestle's decision was deplorable, buy American-made Scharfenberger. But don't try changing the basic rules of corporate governance.
The past ten years have seen a much greater emphasis on investor related goals, such as earnings per share and shareholder wealth. Why do you think this has arisen?
The past ten years have seen a greater emphasis on EPS and Share Holders Wealth but a question arises here is Why it Happened ?. The answer to this question is very varied in terms of scope ,probably because a lot of things are responsible for this change.
In the past ten years investors have become much more organised and professional in terms of their investment decisions, now their portfolios are managed by professional investment managers, they want to be aware of every information related to their investments and moreover they are now having better knowledge of their role and Importance as a Shareholder of any company.
Globalization has also played a very important role in this change because globalization has brought much more competition into the market ,Every company is know aware of the fact that Ones loss is others gain, so they should focus on their duties that is S.H.W.M. Businesses are expanding more than ever and for expansion they need investments and Funding. So, they know they got to give importance to their shareholders otherwise they will loose confidence of their investors and its a very bad signal for any business.Every company is looking for investors and everyone want their Investors to e Long-Term investors. So, inorder to keep investors invested in their company , they have give them best possible return according to the market otherwise, someone else will attract those investors.
The corporate culture and Investment mindset of United States investors has also played a key role in this paradigm shift, because of the I.T. revolution and advancement of ICT industry in United States, too many dot.com companies came up, but to survive in such a competitive market they need to have strong balance sheet and fundamentals and also to keep their investors happy and Invested for longterm they need to perform better than their competitors, this sense of competition has eventually resulted in the Maximisation of shareholders wealth. One very important thing to note here is that every company wants its investors to be long term and they should focus more on capital appreciation/gain and brand image of company rather than on dividends. So, that companies can retain as much earning as possible and reinevestment of the same in Research & Development to become a global leader for all this they need to put very strong balance sheets in front of their investors so, that they forfeit their dividends on much higher capital gain in future.
Corporate governance also plays a very Important part in this change of mindset. Debacle of Enron(2001) was a wake up call for the monitoring bodies to be more stringent in term of regulation of Corporate governance, this created a sense of responsibility and also a fear in managers that if they are going to neglect interest of their shareholders then it be a blunder and repercussions could be that they are thrown out of the company ,they cannot play with the balance sheet of the company and in order to create share holder value they have to give priority to the interest of their shareholders and also they have to do their best to the goals set by the shareholders. Share holder value is very important in this competitive market of today and to attract more investments and clients, managers got build a share holder value and ignorance of this will have a direct impact on the stock price of their company.
In the past Ten years there has been a greater emphasis on Shareholders wealth maximisation or E.P.S, this change has come because of parallel changes taking place in other Economical factors Like U.S. economic boom and long Business development cycle, Creation and burst dot.com bubble , more aware, organised and professional investors and different ways of investing capital like Mutual funds, Pension funds, Life insurance schemes managed by professional investment managers, stringent policies and regulation for Corporate Governance.
- Shareholder Value Maximisation ,Stock Market and New Technology : Should The US Corporate Model be The Universal Stadard. Centre for Business and Research, University of Cambridge Working Paper No. 315 By Ajit Singh and Jack Glen.
- What Drives Shareholder Value ? By Laurence Booth Professor of Finance Rotman School of Management University of Toronto.
- Shareholders Primacy and the Distribution of Wealth By Paddy Ireland Modern Law Review(68(1) ) pp49-81 2005
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- Exposure Draft Simplifying Earnings Per Share Proposed Amendments to IAS 33, August 2008.
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- Shareholders Wealth Maximisation ,Business Ethics and Social Responsibility. By Poitras, Geoffrey. Journal of Business Ethic; Feb 1994.