Value investors look at earnings like a hawk. Improvements in earnings per share (EPS) can come from a variety of sources, but for value investors any increase is usually a good thing. Growth investors, on the other hand, focus on EPS less and are actively disdainful of EPS that comes as a result of financial engineering.
But what exactly does that mean?
To explain, let’s unpack what EPS exactly is.
There are two types of EPS—basic and diluted. Basic EPS is very easy to calculate. You take net income, subtract preferred dividends to it, and divided it by the weighted average number of common shares outstanding. To put it in a formula, it looks like this: N-Pd/Wa = Basic EPS
- N = net income
- Pd = preferred dividends
- Wa = Weighted average number of common shares outstanding
All of these are reported in 10-Q and 10-K filings, so it’s pretty easy to calculate.
Let’s take an example. Imagine a company has 10,000 shares with 2,000 shares issued on July 1st. The company had net income of $10,000 for the year and paid $1,000 dividends to preferred stock shareholders.
Here, the numbers are easy:
- N = $10,000
- Pd = $1,000
- Wa = 11,000
How do we get that 11,000 figure for Wa? Simple. We have 10,000 shares all year, so multiple that by 12 months:
- 10,000 * 12 = 120,000
Then we have 2,000 shares outstanding for half of the year (6 months), so that’s:
- 2,000 * 6 = 12,000
Now combine those and divided that by the total months of the year:
- (120,000+12,000)/12 = 11,000
Things are really easy now:
We get 81.81 cents per share (rounded to $0.82 EPS).
Notice how the EPS would be a lot higher if those 2,000 shares weren’t issued in July. Then we’d have a simple:
- (10000-1000)/10000 = $0.90 cents per share
This is why value investors love financial engineering—and why growth investors don’t like it. Why would a company issue 2,000 new shares? That share issuance raises capital that the firm is supposed to use to fund growth. Share issuance could indicate the company is going to expand—hence growth investors love it.
Value investors, on the other hand, are worried that the share issuance might not be used productively—or, at the very least, we simply can’t know whether the share issuance will ultimately be good or bad. In the short term, it’s obviously bad for earnings.
Of course, the second issue investors would need to look at is revenue growth and a much less financial issue: what exactly will the company do with the cash raised from those shares. If the company has a history of revenue growth, value investors can be at a bit more ease that the new cash can be used productively. If there isn’t, there’s good reason to fret that future revenue growth won’t appear.
At the same time, both value and growth investors would need to look closely at the actual business and the market that it operates in. By doing that, they can get a much better sense of whether that cash can be used productively and ultimately drive higher earnings in the longer term.