Wall Street and the media pays close attentions to every company’s Earnings Per Share (EPS) number. EPS is calculated by dividing earnings (net income) by the total number of shares outstanding. Net income is the bottom line of the income statement. So, net income is the amount that’s left after a company pays off all its operational costs, expenses, taxes, etc. Wall Street analysts want to see a growth in the EPS figure year over year. Consequently, management comes under pressure to show that the company’s EPS numbers are growing every year.
EPS can be manipulated by either adjusting the earnings (net income) or shares outstanding. In this week’s blog post, we will go over the 3 ways in which EPS can be engineered.
- Adjusting the shares outstanding
In the Earnings Per Share number, we can see that the number of shares go in the denominator. So, in order to make the EPS number larger, the management can decrease the number of shares outstanding. The management can do so my buying back its shares. When a company buys back its shares, it reduces the shares outstanding, and in doing so, enlarges the EPS number, without necessarily showing a growth in Earnings.
The company can also mask the issuance of stock options for executive compensation by buying back its shares; this would ensure that when the stock options are exercised, it would not reduce the value of the common stock. For example, company XYZ issues 1,000,000 stock options for its executive. When these stock options are exercised, the shares outstanding would be increased by 1,000,000. This would not only drop the EPS number, but also decrease the existing shareholder’s ownership within the company. In order to mask this excessive compensation, company XYZ would buy back 1,000,000 shares. This would essentially negate the dilution caused by the stock options.
- Capitalize the expense, and depreciate over time
Rather than treating marketing and “soft” costs of doing business as normal expenses, the management may chose to treat them as assets of the company. The process of capitalization pushes the expenses incurred to the asset section of the balance sheet, and that asset is then depreciated over a longer period of time.
For example – Company XYZ had a marketing expense of $1,000, and it believed that this $1,000 had a long term benefit. So, Company XYZ added $1,000 to the intangible asset section of the balance sheet. Company XYZ believed that the useful life of this marketing expense was 10 years, and decided to use straight line method to depreciate this expense. In other words, company XYZ would only report the marketing expense of $1000 / 10 years = $100 on its income statement. As you can see, rather than reporting an expense of $1000, company XYZ will only report an expense of $100 for the reporting period. Needless to say, this would certainly increase the reported earnings, which would inflate the EPS figure.
- Pension Plans
In a company’s retirement plan, an overfunded pension plan means that the company’s plan has more assets than its liabilities. So, the company can report the excess (surplus) towards the company’s net income number. When the stock market increases for a long period of time, many companies would have overfunded retirement plans, which would mean that the EPS number would get a boost from the surplus.
Furthermore, a company can raise the rate of return it expects to earn on its pension plan investment, and this would lower the amount of money the company has to set aside during its current reporting period. This lowering of retirement plan expense would also increase the EPS number. As we can see, this increase in earnings is not driven by improvements in the company’s core business, but rather by adjusting “other income” section of the income statement.
Hope you learned a little and found this blog post helpful. We talked about the 3 ways by which Earnings Per Share (EPS) number can be manipulated. As always, you can sign up for our free mailing list here. You can sign up for our paid subscription services here. Like us on our Facebook page here. Thank you!
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