Monday 20 August 2007

(2)-Share Buy back and Earning per share EPS-Part II

This is part II of the article Share Buy back and Earning per share EPS – Part I. Please start reading this article from the beginning, before proceeding with this part.

So suppose, there are 100 million shares of Utah MP, and are currently trading at 2$ each. So the total value of the company stands at 200 million $. Suppose the company generate an income or earning of 50 million $.

Hence, the EPS of the company becomes = Total Earnings/Total no. of shares

= 50 million/100 million = $ 0.5

Now the company decided to buyback 10 million shares from the investors, at the market price of 2$. So, the investors will be paid a total of 20 million $ and the company will receive 10 million shares from the investors. Hence, the remaining no. of shares will be used to calculate EPS on the same total earnings:

Hence, the EPS of the company becomes = Total Earnings/Total no. of shares

= 50 million/90 million = $ 0.55

This is a clear-cut increase of more than 11% in EPS. Therefore, without actually generating extra earnings or income, the company can still show profitability and increase in EPS year-on-year.

Experienced researchers and equity research teams while looking at EPS also take these factors into consideration, like share buyback or corporate actions. However, we common investors fall victims to such things. If you look for EPS on Google, you will find most of the financial sites mentioning that we should look at past records of continuous growth in EPS year on year. What we fail to realize is how to take into consideration the effects of share buyback and other corporate actions, which are used as effective tools by the companies to make a fool of investors by presenting bloated figures.

Here is the exact data for Utah MP and how it worked:

Year

2001

2000

1999

1998

1997

Shares Outstanding

5210

5978

7197

8273

8495

EPS ($)

1.15

0.9

0.76

0.6

0.5

Over the 5 year period, the company continuously kept on buying back the shares and hence ended up showing a 125% rise in EPS, from 0.5 to 1.15$. Though there was some real growth and a continuous decline in revenue, majority of these figures were bloated because of such schemes of buyback.

As we can observe from the above example, EPS figure may appear to be pretty interesting and effective tool to make a comparison for stock picking or stock selection. However, care should be taken while observing the historical data. One should keep in mind that there may be a big possibility of a corporate action or corporate restructuring, which will result in high values of EPS. As demonstrated above, Utah MP bought back the shares continuously for 5 year period, resulting in a fantastic growth in EPS year on year. People in the accounts department of the company are experts in such tricks. Researchers who are educated know how to adjust the calculations. Individual investors like you and me get trapped with these jazzy numbers. In fact, any data presented on balance sheet or financial results should be looked upon with a doubt, as one figure is derived from the other.

Keep visiting this blog for further content.

Please read the comments and post your views and queries in the comments section which helps in open discussion and avoid duplicity of questions.

You may be interested in reading my previous articles. Here is the link to Table of Contents in a chronological order.

3 comments:

Anonymous said...

Hello Shobhit,

Am just curious to know how can regulatory authorities allow for such manipulations?
You have presented the real figures of Utah Medicals, so obviously companies are following such malpractices. But are the authorities like SEC in US or SEBI in India sleeping? Are there no standards or guidelines for presenting the numbers?

Thanks for the eye-opening truth.

Regards,
Vilas

Anonymous said...

Hello Shobhit,

Thanks a lot for the enlightening article. I've one question. When the companies buy back the shares at premium from the market(secondary i guess), wouldn't there be an expense/liability to the extent of share they bought to offset the additional gain in EPS brought in by way of reducing the outstanding shares

Thanks & regards

IT Correspondent said...

Both the above questions from Vilas and Anonymous are related to the same basic thing: There is no such thing like standard followed while preparing the balance sheet. There are accounting standard like US GAAP, etc. but nothing is foolproof. If one standard item is included in the process, it affects other. The world is not perfect with respect to rules. So that leaves a chance for companies to modify and bloat up the figures

Thanks,


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