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Earnings Per Share - What It Won't Tell You

|Includes: Bed Bath & Beyond Inc. (BBBY)

Earnings per Share (NYSEARCA:EPS) is one of Wall Street's most commonly used metrics to gauge a company's financial success. This metric seizes all of the headlines and has stock analysts pouring over their fair value calculation spreadsheets for hours and hours looking at each company's previous 10-year EPS numbers.

The metric tells you how much of a particular company's earnings are represented in just one share of the company.

For example, JP Morgan's current trailing 12-month EPS is 5.54. Therefore, if you own one JP Morgan share, your portion of the company has generated 5.54. Obviously, the higher the number, the better - and healthy companies tend to increase this number each year.

There are, however, some major flaws with relying TOO heavily on this one metric as a tool for year-over-year (YOY) comparison.

The EPS metric is one of the EASIEST manipulated metrics and, in and of itself, does not truly indicate the relative strength of a business on a macro level.

It is not enough to simply rely on EPS numbers in earnings

It seems odd and somewhat naïve to simply take the EPS number as it is and not consider the two drivers behind the number.

1. Total net income for a company (this can be manipulated as well, but is more difficult to hide)

2. The second driver of the EPS number is the outstanding shares that are in circulation. If less shares are in circulation, the denominator in the equation will be smaller and the EPS will be larger as a result.

Share buybacks & repurchases

Reducing outstanding shares is most commonly put into practice with what are called "share buybacks" or "share repurchase" programs. In these cases, companies use cash or debt in order to actually purchase shares of their stock. Then, they will eliminate the shares they just purchased.

This decreases the amount of shares outstanding, giving each share more value in the process.

Most investors love share buybacks, because it gives the shares that they currently own more value and will often be a catalyst for higher stock prices in the near future.

EPS Manipulation Using Buybacks

The problem arises when share buybacks and EPS numbers muddy the water for analysts so that it is more difficult to understand the relative health of a corporation.

Check out the chart below, showing Bed Bath & Beyond's (NASDAQ:BBBY) EPS over the past 5 years.

Keep in mind, these are the most well-reported numbers and are what many base their forecasts on for a company's future growth. Based only on this chart, it seems as if BBBY is steadily growing, increasing shareholder value, and poised for success down the road.

However, look at the chart below which shows the total net income for the company over the same time period:

Not exactly the same story is it?

Now, this does not necessarily mean that the company was trying to hide anything. They may have foreseen this drop in revenue and decided that it was crucial to buy back shares in order to keep their share price from plummeting. This would be a fair response for management and likely saved their investors a lot of headache.

Once again, EPS is still a crucial element to a company's earnings and helps each investor understand how large of a piece of the pie he owns. The point is that the EPS metric should not be THE ONLY good measure of a company's performance - Bed Bath & Beyond may be able to keep us a stock price for a while based on EPS growth, but eventually the company's operating earnings will come into play and will either push the company further or begin to slowly sink it.

Best metric is operating earnings

With that said, the metric that I believe is one of the best for analyzing a company's profitability year over year is operating income (as a total, not per share). This simply shows us how much the company made from their actual operations and it can take out a lot of exterior or macroeconomic noise from the equation.

Hope this was helpful on some level to you! During my next post, I will outline a couple stocks that are currently rolling out large buyback problems but who also have very strong balance sheets and operating results. Many of these stocks are also trading at a discount to their peers.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.