Earning per share (EPS), the key ratio

Earning per share (EPS), is perhaps the most important data from an investor's point of view. It is a definite indication of what the company has earned for the shareholder, post tax. If a shareholder takes the figure, calculates its percentage against the price he paid for the share he knows his rate of return. Comparing this rate with an equivalent rate, say that of government securities, or bank fixed deposit he will get to know whether the company has earned more for him or less.

The logic here is simple. An investor can, and should, consider all net profits of the company to be his, to the extent he owns the equity. If just one owner owned the entire stock, the entire net profit of the company would be his. A partial owner therefore can stake a claim on the profit to the extent of his stock holding.

In security investment, he, the partial owner, does not receive the profits in hand but as we shall see that is to his advantage. He believes that if the company continues to earn a steadily growing EPS and reinvests it, the market will eventually realize the fact and the price of the stock will go up. And that is what he wants! Mary Buffett, who was married to Warren Buffett's son for some time, explains this as the basis of Warren Buffett's investment philosophy, in her book 'Buffettology'.

Let us take a few specific examples for clarity. Bombay Dyeing declared a net profit of Rs. 431.6 Million for the year 1999-2000 against 41 million outstanding shares. This gives an EPS of Rs. 10.53 per share. For an investor who had purchased a Bombay Dyeing share for Rs.50, a year ago, this works out as a return of 21% on his investment. If the investor had invested the same Rs. 50 in a bank deposit at say 10%, he would have earned Rs. 5/-. Obviously he perceives investment in Bombay Dyeing share as a better proposition.

The difference here is that the amount earned by Bombay Dyeing for the investor has not come to him (we shall consider the dividend amount a little later) while that earned in the bank would. Now, if Bombay Dyeing were to give a promise to the investor that it will earn an EPS of Rs.10.52 every year, for next ten years, which translates into a compound rate of return of 21%, the investor may very well choose to maintain his money in the share. Such a certainty will give the Bombay Dyeing share a strong edge over many other investments and though the money does not reach the investor, the market sooner or later takes notice and revalues the share to a higher value, which is what the investor desires.

In the above example if the investor had paid Rs. 100 for the share, his return would have been only about 10%. The price paid by the investor determines the return. Lower the price, higher the return and vice versa.

This is the point where the argument whether a company should pay a dividend or not comes into play. Bombay Dyeing decided to pay Rs. 3 per share as dividend. If there were a reasonable certainty that Bombay Dyeing would earn the same EPS next year our investor is in trouble. He would have to invest those Rs. 3, which the company has given to him to earn a return of 21% minimum. For a small investor this is too heavy a responsibility.

He would rather not take the dividend and request Mr. Nusli Wadia and his management to reinvest his dividend for him in the company and again earn the same EPS. For the investor who paid Rs. 100 per share, the dividend is welcome because he invests that amount in the bank without any sense of loss. Once again it is the price one paid for the share decided the thinking. Warren Buffett's Berkshire Hathaway and Microsoft of Bill Gates do not pay any dividend and the shareholders do not mind it. These companies earn more per share income year after year than one would earn elsewhere, of course for the price originally paid for the security. Share prices of all these companies get quoted at high P/E multiples.

People like Warren Buffett, therefore argue that if the company management is capable of retaining and using the shareholders income profitably, to give a consistently high rate of return, it should do so and not pay any dividend, unless the shareholder has an avenue open to him to earn a greater return. If the company is saddled with lots of money, which it does not know how to invest in the current business, it should go out and buy some other profitable business or simply buy back its own shares (consider the example of Bajaj Auto Limited). The assumption here is that a good management knows better how to invest the available funds than a lay investor, which of course is generally true.

Critical element in this thinking is however the certainty factor. Can an investor be certain that the company will earn the same or increasing EPS in future? Therefore the skill of the analyst lies in judging the certainty of return. Further, to take full advantage of the great power of compounding, the investor should be patient enough to wait for long enough time. If the company continues to give a high and increasing rate of return the investor should never sell the stock and allow its price to go up and up. Warren Buffett has followed this philosophy which he learned from Philip Fisher. This also is a point where Buffett deviates from his mentor Benjamin Graham.

To understand the certainty factor let us look at Bombay Dyeing record. Earlier we considered Bombay Dyeing giving an assurance of earning the same EPS for next ten years but a look at the company's record says a different story. The figures are taken from the company's annual report. EPS figures indicate Rs. per share rounded to nearest Re.

Bombay Dyeing
Year	90-91	91-92	92-93	93-94	94-95	95-96	96-97	97-98	98-99	99-00
EPS	16	20	16	20	30	31	9	6	5	11

No certainty is evident in the EPS figures. The table shows that the EPS, after oscillating for four years around the mean figure of 18 has suddenly jumped by 50% and then has gone way south in 96-97. This unpredictability may drive away a serious investor and only speculators will be attracted towards the counter. An investor, who purchased the share at Rs. 100 (The high was Rs. 306 and low was Rs. 85 in 96-97) in late 96, thinking that he would get a return of 31%, actually got a return of only 9% and it went further down during the next two years. In these years, however, the company continued to give Rs. 3.50 as dividend and investor could take it and reinvest it at 12-13% and get some higher returns.

There are some companies, which show a growth in EPS every year. Investors love such companies and because of the fickle nature of the market these securities are some times available at throwaway prices. Let us first take a look at HDFC Bank. These figures are taken from the latest annual report. Unlike Bombay Dyeing though these are for last five years only.

HDFC Bank
Year	95-96	96-97	97-98	98-99	99-00
EPS	1.04	2.03	3.16	4.12	5.93

The compounded growth rate for the EPS is a staggering 54% without a drop in any of the years. This share was available for Rs. 53 in February 99. Market, among other things, has perhaps noted this growth in earning and has gone after this share which is being quoted around Rs.220/250 currently. Investors feel certain that the growth in EPS will continue. In this particular case merger with another bank viz. Times Bank, probably acted as a catalyst to attract the attention.

Market is definitely fickle because we shall now see a case of growing EPS yet a falling price, that of LIC Housing Finance. In February this year the share was available at about Rs.35/40. Currently it is being traded at about Rs.31/32.

LIC Housing Finance
Year	94-95	95-96	96-97	97-98	98-99	99-00
EPS	5.5	6.9	8.4	11.97	13.48	14.54

Here the compounded growth rate in EPS is 21.5%. The share is available today for around Rs.31. If the company continues to give the EPS along the same trend, the EPS in 2000-01 will be Rs. 17.66, which on a purchase price of Rs. 31 works out to about 57%. If an analyst is certain about the company's performance in coming years he may recommend his clients to buy this share. In such a case, according to Buffett, the share looks like a bond with a variable rate of interest. He hopes that sooner or later the market will realize the growth and scale the price upwards. Generally on a long term the market tends to award such shares.

Finally let us take a look at Infosys. We will look at the share from 1992 onwards and we will adjust the EPS for the share split of 1999 but ignore the bonus issues in 95-96 and 98-99. Please also note that in 1994 the market price of the Rs. 10 share was around Rs.600/650.

Infosys
Year	92-93	93-94	94-95	95-96	96-97	97-98	98-99	99-00
EPS	12.48	17.76	24.14	18.50	28.90	46.00	37.70	84.30

The compounded annual growth is at 31.4 % and still growing. A sustained growth over such a long period can not go unnoticed. The Rs. 5 share is trading currently at about Rs. 5,500/-

Thus in Buffettology three things become very important. The per share earning and its growth rate, the certainty of the per share earning and the price one pays to buy the share. If all three are favorable the share becomes very attractive. To predict the future growth in EPS, one must understand the business and also the economy. It is not easy and since no one can predict future with certainty some element of uncertainty will persist. Skill lies in reducing that element. Mary Buffett explains that "Without some predictability of future earnings, any calculation of future value is mere speculation and speculation is invitation to folly."

The above discussion will also enlighten the reader about the importance of P/E ratio because the ratio offers a direct relationship between the EPS and the price. A low P/E multiple immediately draws attention to the share. It is an indication that the earning is high but the market has decided to overlook the share for some reason. If an analyst goes deeper and studies the past record, he may discover a trend that tells a tale contrary to what the market is assuming. In that case the share becomes attractive.

Fear and greed drive the security market. A long-term value investor learns to disregard the market sentiment and to depend upon his own judgement. When the fear mentality is pushing the prices down he sees it as an opportunity to jump into the pit and pick up the goodies at low prices. Having picked them he goes to sleep with an assurance that when the market turns greedy it will realize the value of his goodies and reward him. On short-term the market is a voting machine but on long term it is a weighing machine.