This column covers fundamental analysis, which involves examining a company’s financial
statements and evaluating its operations. The analysis concentrates only on variables directly related
to the company itself, rather than the stock’s price movement or the overall state of the market.
Earnings per
Share
As an individual investor managing
your own stocks, you undoubtedly
follow earnings closely, since these
reported figures can greatly affect
the price of a stock. Unfortunately,
earnings are never straightforward
and can be calculated several ways.
In fact, depending on where you look
for earnings data, there can be vastly
different figures given for the same
company. This is due to the fact that
firms and analysts can treat the items
used to calculate earnings differently.
You may have noticed that firms
will often report several variations
on their earnings figure. A standard
set of accounting rules and procedures, known as GAAP (generally
accepted accounting principles), applies when reporting earnings figures
and compiling financial statements.
U.S. companies must abide by GAAP,
making it difficult for firms to report
faulty figures and ensuring that earnings figures are comparable among all
publicly traded firms.
However, GAAP earnings figures
do not always accurately represent
the earnings for a firm. To make
earnings more comparable from period to period and with other firms,
analysts often “adjust” their earnings,
leaving abnormal and nonrecurring
income and expenses out. The goal
is an earnings figure that is a more
accurate representation of the firm’s
true core business earnings potential.
In this Fundamental Focus, different types of earnings per share
figures are explored. In addition, a
detailed example shows how different
earnings adjustments can radically
affect reported earnings.
GAAP Earnings
GAAP earnings prepared by a
company meet the generally accepted
accounting principles. This earnings
per share figure is the number used
by companies when filing their SEC
statements, which are all audited
by outside auditors. Companies will
always report earnings in accordance
with GAAP, but some may also report adjusted figures.
There are several different GAAP
earnings that companies may report. You need to make sure you
know which earnings figure is being
reported to stay consistent when
comparing earnings figures. The three
most common GAAP earnings are:
• basic earnings per share,
• earnings from continuing operations and
Figure 1. Microsoft Corp.’s Fourth-Quarter Earnings Announcement
Three Months Ended
June 30,
(In millions, except per share
amounts and percentages)
2012 As reported (GAAP)
Revenue
$18,059
Goodwill impairment
Operating
income
Diluted
EPS
$192
($0.06)
$6,193
$0.73
Windows Upgrade Offer
$540
$540
$0.06
2012 As adjusted (non-GAAP)
$18,599
$6,925
$0.73
2013 As reported (GAAP)
$19,896
$6,073
$0.59
($782)
($782)
($0.07)
$19,114
$5,291
$0.52
Office Upgrade Offer
2013 As adjusted (non-GAAP)
*not meaningful
Source: Microsoft Corp., July 18, 2013.
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Percentage Change
Revenue
Operating Diluted
income
EPS
10%
*
*
3%
(24)%
(29)%
• diluted earnings from continuing
operations.
Basic earnings per share is simply a
firm’s net income less any preferred
dividends divided by the average
number of shares outstanding. It
measures the amount of earnings a
firm generates for each share of outstanding common stock.
Earnings from continuing operations describes earnings from a
company’s “core” business operations
that it is expected to operate for the
foreseeable future.
For example, a technology firm that
accrued a gain on the sale of assets
would not include that gain when
calculating earnings from continuing
operations, as the sale was a onetime event that will not be recurring
period after period.
Management has some leeway in
deciding what income and expenses
to exclude when preparing earnings
from continuing operations. However, the figure has to be prepared
according to GAAP and is highly
scrutinized by auditors.
Diluted earnings from continuing
operations is also reported by companies if potentially dilutive securities
are a part of its capital structure.
Dilutive securities are financial instruments that, if exercised, increase
the number of outstanding common
stock. These include stock options
and warrants, convertible bonds and
convertible preferred stock. Diluted
earnings from continuing operations
calculates a company’s earnings per
share using a fully diluted shares
outstanding number, which includes
the impact of all outstanding dilutive
securities. In essence, it represents
the “worse-case scenario,” since
the exercise of all dilutive securities
would reduce earnings per share.
Adjusted Earnings
Adjusted earnings, or “pro-forma”
earnings, is a non-GAAP figure
calculated by company management
or analysts. It is used in an attempt
Computerized Investing
Figure 2. Microsoft Corp.’s Earnings as Calculated by Scottrade
Source: Scottrade.com.
to present a figure that is a better
representation of a firm’s profitability
and business outlook. Whether this
adjusted figure actually accomplishes
that task is up for debate.
Items that are commonly left out of
adjusted figures include restructuring
and merger costs, losses at affiliates,
goodwill write-downs and other onetime expenses. In addition, management may also even leave out depreciation, amortization and stock-based
employee compensation.
When a company releases adjusted
earnings, make sure to note the key
differences between the adjusted
figure and the reported GAAP earnings figure. Adjusted figures are not
subject to the same level of regulation as figures reported in accordance
to GAAP. However, management is
required to present the differences in
GAAP and adjusted earnings figures.
It is up to the investor to make sure
adjustments were sensibly made.
A Closer Look
Looking at Microsoft Corp.’s
(MSFT) last earnings release can help
illustrate the differences in earnings
figures. Figure 1 shows Microsoft’s
fourth-quarter 2013 earnings announcement, released on July 18,
Fourth Quarter 2013
2013, giving two diluted earnings figures: one in accordance with GAAP
and one adjusted figure that does not
follow GAAP. GAAP diluted earnings
were reported at $0.59 per share.
During Microsoft’s fourth quarter,
there was an income and an expense
that deserve further scrutiny. During
the quarter, Microsoft was having
trouble selling the Surface RT tablets
and lowered the price of the tablet
from $500 to $350. Accordingly, the
company wrote down their inventory by $900 million and charged the
expense to the quarter as required
by GAAP rules. The fourth-quarter
financial results also include the
recognition of $782 million of previously deferred revenue related to
Microsoft’s Windows Update offer.
This Windows Update offer allowed
buyers of Windows 7 (after Windows
8 was announced) to upgrade to Windows 8 for $14.99. Following GAAP
rules, the revenue from this upgrade
offer was recorded as revenue for the
fourth quarter of 2013.
This income and expense are both,
arguably, one-time nonrecurring
items that can be reasonably adjusted. Microsoft took the conservative route and adjusted their earnings
downward, taking out the revenue
from the Windows Update offer
but leaving in the expense from the
Surface write-down. The company incurred a $0.07 per share expense for
the write-down and reported adjusted
earnings for the quarter of $0.52 per
share, compared to GAAP earnings
of $0.59 per share.
Websites such as Reuters and
brokerages such as Scottrade chose
to adjust Microsoft’s earnings in the
completely opposite manner, adding
back the $0.07 per share expense
incurred by Microsoft for the Surface
write-down and leaving in the extra
income earned through the Windows
Update Offer. Therefore, Reuters and
Scottrade both report earnings of
$0.66 per share for Microsoft in the
fourth-quarter of 2013, as shown in
Figure 2. Stock Investor Pro, AAII’s
stock screening and research database, also lists $0.66 per share.
Conclusion
It is imperative to understand how
any earnings figures are derived.
Companies that present an adjusted
figure are required to show how it
differs from earnings reported in
accordance with GAAP. But it is
ultimately your responsibility as an
individual investor to decide whether
the adjustments make sense.
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