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Chapter 2. Earnings

Before we can cover the P/E itself, we should first define its more complicated component: earnings. This chapter covers the basics of the different ways in which earnings and then earnings per share (EPS) can be defined. I move downwards through the profit and loss account and discuss the different figures as more and more costs are deducted from profits. The discussion is purposely kept general here; for a practical example, see the later chapter on Haynes. I do not intend to give a detailed explanation of company accounts, as many other books do this; I cover only the components of the earnings calculation.

From sales to operating profit

The basics need little explanation.

A company produces goods or services and sells them; the amount the company receives here is termed the sales (or turnover, or revenue). From this figure of sales we need first of all to deduct the cost of the items sold to calculate the gross profit.

However, we have not yet reached the first figure that counts as earnings, because many expenses must be taken into account on top of raw materials, such as staff costs, IT, rent and so on. Other notional expenses, such as depreciation and amortisation, are also deducted. These are not necessarily items that have caused us to actually spend any cash this year, but they need to be deducted regularly from gross profit in any case. Declared profits would be excessively variable if large occasional expenditures on capital items were recorded as they happened. There is anyway a separate Consolidated Cash Flow statement.

‘Earnings’ as a word on its own is in fact a rather ill-defined catch-all term for any of the profit figures we now cover. The initial figure for earnings is the difference between revenue and the total of these costs – basically all the costs of the company excluding finance charges and tax. This initial earnings figure is called operating profit.

Towards the P/E’s earnings figure

Operating profit is the highest figure up the profit and loss account that is referred to as ‘earnings’. However, there are two unavoidable costs of running a business that still remain to be taken out: interest paid to service loans, and tax. Subtracting interest paid gives profit before tax. Finally subtracting tax paid gives profit from continuing operations. (Details of any discontinued operations will appear in a separate column in the profit and loss account.)

Now all the necessary deductions have been made to the profit, a ‘clean’ figure is available to distribute to shareholders or into the company reserves. It is this profit from continuing operations that is used in EPS calculations.

EBIT and EBITDA

These ungainly acronyms have become increasingly popular in recent years. EBIT stands for earnings before interest and tax, and EBITDA for earnings before interest, tax, depreciation and amortisation. There are times when they may legitimately be used. For example, EBITDA is often used in loan covenants, partly because the bondholders are not concerned about tax payments – interest payments are made before a company’s tax liability is calculated.

However, it is hard to avoid the impression that EBIT and EBITDA have become so widely quoted because they make every company’s earnings look better. It is always a bad sign to come across a company proudly quoting its EBITDA in the first few pages of graphics in its annual report, instead of profit figures from further down the profit and loss account. Often a few seconds with a calculator will show that the company has little or no chance of ever making a real profit, because its amortisation charges more than wipe out the operating profit each year.

EBIT and EBITDA have been memorably if unkindly described as “look how much we could have earned if we didn’t have to pay our bills”. Interest on loans and tax are unavoidable costs of running a business and really should be taken account of. If the company sourced its capital from shareholders, instead of borrowing the money, then it would presumably have to pay dividends instead of loan interest. Tax is sadly unavoidable for us all, and does at least help provide a safe legal framework in which the company can operate. Depreciation and amortisation are even more basic expenses that have already been subtracted before the operating income is reported. As Warren Buffett asked: “Does management think the tooth fairy pays for capital expenditures?” I do not use EBIT or EBITDA further here.

Basic, diluted and adjusted EPS

Having calculated earnings with all necessary costs taken out, we can now move from the company level to the per-share level. EPS is calculated by dividing profit from continuing operations by the number of shares in issue. This is basic EPS.

However, the company may well have options grants outstanding to executives, and sometimes to employees too, which will vest if certain targets are attained. These give a higher number of possible shares in the future. Dividing profit by the number of all the shares that exist now or might possibly vest gives diluted EPS.

The figure often quoted in the financial press is adjusted EPS (also known as headline EPS). This uses earnings with exceptional items excluded – large, one-off costs such as the expense of closing down an unprofitable division. Unfortunately, the exact definition of what is classified as ‘exceptional’ varies by company – the company’s accountants have wide latitude over the accounting figures.

Historical, rolling and forecast EPS

Another possible dimension to the stated EPS figure is whether it is historical or forecast. Historical EPS is the simplest and is what has been covered above, i.e. the earnings stated in the company’s most recent annual report.

Rolling EPS is based on the latest available earnings information. In the UK, if the six-monthly interim report has come out, the earnings from the first half of the annual report drop out and are replaced by these most recent earnings. US companies, and many large companies that are quoted in the US such as BP, declare results quarterly, so for them the rolling figure is the most recent four quarters. These six-monthly or quarterly announcements are unaudited, so unlike the figures in the annual report they are subject to review.

Forecast EPS does not come from the company, although they may provide guidance. It is the average of the earnings expected to be declared for the current accounting period, as forecast by the analysts who cover the company. For a large company in the FTSE 100 this will mean a dozen or more analysts’ forecasts being available at any one time.

Since we are interested in the returns to be had from the company in the future, not the recent past, why do we not always use forecast EPS and forget about historic EPS? The major problem here is that forecast EPS will usually be quoted only if three or more analysts follow the company. Forecast earnings are thus available only for the few hundred largest UK companies – effectively, members of the FTSE-350 Index plus a few others. Of the roughly 1,300 trading companies quoted in London, there are hundreds with a market capitalisation of less than £50m. These are unlikely to have even three analysts covering them, particularly if they are quoted on AIM. Such companies have no forecast earnings and thus no prospective P/E figure.

Because of this limited coverage offered by forecast earnings, academic research to back-test particular trading rules invariably uses historical EPS, not forecast EPS. (The fact that you have to pay for a higher DataStream subscription level to get the analysts’ forecasts, and few universities can afford to do so, may also be relevant!)

Problems with earnings figures

There is a significant problem near the top of the profit and loss account. Operating income, being one large number (sales) minus another large number (costs), may be highly variable. Depending on the industry and business model, perfectly healthy companies may nevertheless have wafer-thin profit margins.

For example, Inchcape import and distribute thousands of cars every year. Given the huge volume of metal moving through their distribution channels, a 1% or 2% profit margin is very healthy. However a small percentage change in either sales or costs leads to a very large change in the operating income. Forecasting earnings figures for such companies is therefore a particularly error-prone business. Forecast earnings depend acutely on the assumptions made about how gross sales and total costs will change in the future.

Another sticking point when calculating earnings is that sales in any one year, and hence earnings, are easily manipulated. It was mentioned above that what is classified as an exceptional cost, and thus to be excluded from adjusted EPS, is a matter of opinion. The company’s managers are likely to take a more liberal view of what costs are exceptional than a potential investor. Some large companies seem to need to close down an unprofitable division or operations in some particular county every year, but they still book it as exceptional. When this seems to happen year after year, one is entitled to ask how exceptional it really is.

A whole branch of academic finance literature exists on the manipulation of earnings and how it may be identified. The dividing line between current managers wanting to present their actions in as positive a light as possible, and fraud, is not necessarily easy to draw. Any investor who follows the market for any length of time will have read about scandals of companies booking sales before they are absolutely definite, so as to enhance the apparent performance of the sales managers responsible and thus their bonuses. A recent well-publicised case is Findel, who run Kleeneze among other businesses. In 2010 their educational supplies division was found to have been making “unsubstantiated accounting entries”. Earnings had to be restated, the shares of the Group fell precipitately and have not yet recovered.

One final problem is the practical indeterminacy of EPS figures. Trying to pin down the precise basis of any particular basic, diluted, adjusted, forecast, rolling or historical EPS figure offered you is a real can of worms. Three different financial data sources, such as DataStream, the Financial Times and Hemmington Scott’s Company REFS will likely provide three different figures for EPS. However closely you read the online help files, unless you work as one of their data analysts and are able to read the computer code you will probably never know what exactly they include and exclude in their EPS figure. Even when I have sat down with a copy of an annual report and tried to work out exactly where an EPS figure came from, I have usually been unsuccessful. However, as long as you are using the same definition for all the companies you are considering investing in, it is unlikely to be a decisive factor.