EPS 77 5.14 EPS from continuing operations 79
3.3 Use of EPS in financial analysis
South African shares listed between 1980 and 1999 (20 years) were selected. Sixty three companies remained listed over this period. Linear regressions were firstly estimated to test the relationship between Basic EPS and share prices. Linear regressions were then estimated to test the relationship between share prices and Cash flow per share.
The share prices used were the closing prices on the last day of trading of the particular company's financial year. The EPS numbers were those actually reported by the companies. The numerator used in the calculation of Cash flow per share was the "cash flows from operating activities" less dividends paid to preference shareholders and minorities. The denominator used for Cash flow per share was the same as for Basic EPS.
De Villiers et al found that both Basic EPS and Cash flow per share had an effect on share prices. However the study found that Basic EPS had a higher correlation with share prices than Cash flow per share.
De Villiers et al concluded that Basic EPS has more explanatory power on share prices than Cash flow per share confirming that the analysis of EPS is economically meaningful, despite the criticisms brought against accounting profits (2003:124). The De Villiers et al study showed that earnings based measures are more economically meaningful than cash flow measures.
Even though EPS may be the most used ratio in financial analysis, the ASB's primary objective in revising FRS 3 was to remove any reliance on a single figure to measure company's earnings. The ASB maintains that as long as all the relevant information is available in the "accounts, how analysts choose to interpret the figures is entirely up to them" (Accountancy 1993:14). This sentiment is stated clearly in UKSIP 1 where investors are encouraged not to rely on any one measure of profitability but rather consider a range of information and measures in their analyses.
By surveying the attitudes of a certain category of users, Suliman (2000) studied the extent to which the various EPS measures are used in financial analysis. The user group surveyed were unit trust managers and evidence was obtained on the usefulness of various measures of performance.
Postal opinion research was used for purposes of the Suliman (2000) study with customised questionnaires being sent to 106 equity unit trust managers. The unit trusts were selected from the 1999 Unit Trust Handbook. Twenty eight responses were received. Relevant findings of the Suliman (2000) study are presented.
Suliman (2000) asked the fund managers which factors they considered when investing or disinvesting in shares. The results to this question, as presented in Appendix A of her study (p 111), are presented in table 3.2.
The results show that a company's financial performance is the most important factor when making investment decisions with 25 of the 28 respondents indicating that they
"always" considered financial performance when investing. Sentiment (e.g.
empowerment shares) and instinct are also used with some frequency. Public opinion is usually not a factor.
Table 3.2: Suliman (2000) study - Factors considered when trading in
1 2 3
Always Almost Somet
no
Financial performance 25 Sentiment
(e.g. empowerment shares) 6
Instinct 4 Public opinion 2
Source: Suliman (2000: 111).
Always
% no % no
89 3 11 0
21 5 18 14 14 7 25 13
7 1 4 7
mes
%
0
50 46 25
4 Seldom
no
0
2 3 9
%
0
7 11 32
i s h a m
5 Never
no
0
1 1 9
%
0
4 4 32
Mean
4.89
3.46 3.36 2.21
Rank
1
2 3 4
Suliman also asked the fund managers to rank the various EPS measures in terms of their usefulness in financial statement analysis (ranking them from 1 to 5, 1 being most useful and 5 being least useful). The results, as presented in Appendix A (p 122) of her study, are presented in table 3.3.
The results show that the fund managers consider Headline EPS to be the most useful EPS measure with a high degree (mean of 4.4 out of 5) of usefulness attached to it.
Diluted EPS is considered to be more useful than Basic EPS and Cash flow per share.
Little usefulness is attached to Basic EPS and Dividends per share. Due to the Basic EPS weaknesses discussed in Chapter 2, it is not surprising that Basic EPS has a low usefulness ranking.
Table 3.3: Suliman (2000) study
Basic EPS Diluted EPS Headline EPS Cash flows per share Dividends per share
Source: Suliman (2000:122)
1
-Usefulness of EPS
Rankl
no 2 7 18
1 0
% 7 25 64 4 0
2 Rank 2
no 2 9 4 10
3
% 7 32 14 36 11
3
measures
Rank 3
no 3 6 5 8 6
% 11 22 18 28 21
4 Rank 4
no 10 4
1 8 5
% 36 14 4 28
18
5 Rank 5
no 11 2 0 1 14
<7c
39 7 0 4 50
Mean
2.07 3.54 4.4 3.04
1.93 Rank
4 2 1 3 5
Based on the results of her survey, Suliman (2000) showed that financial performance (earnings) of a company is the most significant consideration when making buy or sell decisions on capital markets. Also, of the various EPS measures, Headline EPS is the measure considered most useful by institutional investors. This finding is consistent with the Hemus and Mildenhall (1995) study which showed that a measure similar to Headline EPS was most correlated with share prices.
With regards to Diluted EPS, the findings of Suliman (2000) support the findings of Balsam and Roland (1998). Balsam and Roland (1998) showed that there is a greater correlation between Diluted EPS and share prices than there is between Basic EPS and share prices (Balsam and Roland 1998:247). Suliman (2000) showed that users consider Diluted EPS as having more information content than Basic EPS.
The results of the Suliman (2000) study also show that institutional investors prefer earnings based measures (Headline and Diluted) to cash flow based measures. This supports the finding of De Villiers et al (2003) who showed that Basic EPS was more correlated with share prices than Cash flow per share. This finding is significant as earnings based measures are often criticised with many commentators suggesting that Cash flow per share is a better measure than the earnings based measures.