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Journal of Education for Business
ISSN: 0883-2323 (Print) 1940-3356 (Online) Journal homepage: http://www.tandfonline.com/loi/vjeb20
Should Earnings Per Share (EPS) Be Taught as a
Means of Comparing Intercompany Performance?
Charles E. Jordan , Stanley J. Clark & W. Robert Smith
To cite this article: Charles E. Jordan , Stanley J. Clark & W. Robert Smith (2007) Should
Earnings Per Share (EPS) Be Taught as a Means of Comparing Intercompany Performance?,
Journal of Education for Business, 82:6, 343-348, DOI: 10.3200/JOEB.82.6.343-348
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ShouldEarningsPerShare(EPS)
BeTaughtasaMeansofComparing
IntercompanyPerformance?
CHARLESE.JORDAN
STANLEYJ.CLARK
W.ROBERTSMITH
UNIVERSITYOFSOUTHERNMISSISSIPPI
HATTIESBURG,MISSISSIPPI
ABSTRACT.Accountingstandardsstate
thatthepurposeofpresentingearningsper
share(EPS)istoprovidefinancialstatementuserswithinformationontheperformanceofasingleentity.Yet,severaltextbookauthorsgofurthertostatethatEPS
canbeusedtomakecomparisonsamong
firms.Inthisarticle,theauthorsshowthat
althoughEPScomparisonsamonglarge
publiclytradedcompaniesmaybeappropriate,suchcomparisonsshouldnotbe
madeamongsmallpubliclytradedfirms
becausethenumberofcommonsharesoutstandingrepresentsapoorscalingmeasure
forentitysize.Assuch,accountingprofessorsshouldrefrainfromteachingEPSasa
toolformakingintercompanyperformance
comparisonsorattheveryleastshould
warnstudentsofthepitfallsofmakingsuch
comparisons.
Keywords:earningspershare,EPS,performancecomparision
Copyright©2007HeldrefPublications
A
ccounting professors often cite
earnings per share (EPS) as
a measure of company performance.
When Wall Street analysts forecast a
firm’s earnings, they are prognosticatingEPS.EPSissignificantbecausethe
market reacts to an entity’s ability to
meet its earnings expectations: falling
short of expected earnings by even a
fewpenniespersharecancauseaprecipitousdropinstockprice.
AsNikolai,Bazley,andJones(2007)
noted, the amount of EPS for a period
andthetrendofEPSforseveralperiods
for an entity represent important measures of success and are also long-run
indicators of cash flows. Although the
current EPS standard (i.e., SFAS No.
128, Earnings Per Share) says little
about the purpose of EPS, previous
standards shed some light on why this
performance measure exists (Financial
Accounting Standards Board, 1997).
TheAccountingPrinciplesBoard(APB;
1966) in Opinion No. 9, Reporting the
ResultsofOperations,statedthat
when presented in conjunction with formalfinancialstatementsforanumberof
periods[EPS]canbeuseful...inevaluating the past operating performance of
a business entity and in a attempting to
form an opinion on its future potential.
(para.30)
In Opinion No. 15, Earnings Per
Share,theAPB(1969)saidEPSshould
“assisttheinvestorinweighingthesig
nificanceofacorporation’scurrentnet
incomeandofchangesinitsnetincome
fromperiodtoperiod”(para.1).
TheAPB’sstatementsshowthatEPS
is significant because it evaluates a
single entity’s performance over time.
EPS was originally a way to analyze
the accomplishments of a single company and not a means to compare the
earnings of multiple firms. Yet, many
textbookauthorshavestrayedfromthe
original intent of EPS; they suggest
thatitallowsperformancecomparisons
among firms. In addition to pointing
out this discrepancy in textbooks on
the purpose of EPS, in this article we
also attempt to empirically answer the
question of whether EPS represents a
valid method of making intercompany
performancecomparisons.
BackgroundandPriorLiterature
As previously discussed in the professionalstandards,educatorsoriginally
presentedEPSasamethodofevaluating
theearningsperformanceandpotential
ofasingleentity.Manyaccountingtextbookauthorshaveremainedtruetothis
originalpurpose.Forexample,Williams
(2000)statedthat“EPSfiguresareused
to evaluate the past operating performanceofabusinessinforminganopinionconcerningitspotential”(p.14.04).
Williams did not mention using EPS
to compare the performance of mulJuly/August2007
343
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tiple firms. Nikolai et al. (2007) noted
that the price/earnings (P/E) ratio (i.e.,
marketpricepersharedividedbyEPS)
allowed for intercompany comparisons
becauseitrepresentedthevaluethemarketplacesonashareofstockrelativeto
thecompany’searnings.Forexample,a
P/Eratioof15foronecompanyand10
foranothersuggeststhemarketismore
optimistic about the former company’s
futureearningspotential.However,this
comparisonisnotbetweenfirms’EPS,
but rather, the market’s perception, as
reflectedinshareprice,offutureearningspotential.
Several accounting textbook authors
take a different view in explaining the
purpose of EPS. For example, Needles
and Powers (2007) noted that financial
statement readers used EPS “to judge a
company’sperformanceandtocompare
it with the performance of other companies” (p. 623). Spiceland, Sepe, and
Tomassini (2007) suggested that SFAS
No.128ensuredthatrulesforcomputing
andpresentingEPSmaximizedthecomparability of EPS numbers “from one
company to the next” (p. 965). Schroeder,Clark,andCathey(2005)succinctly stated this view of EPS when they
claimed that “analysts, investors, and
creditors frequently look for some way
tocondenseafirm’sperformanceintoa
single figure, some quick and efficient
waytocomparefirms’performance.EPS
servesthispurpose”(p.175).
Thus, a dilemma exists in how professors are teaching EPS to accounting and other business students. Many
textbooks remain true to the original
designofEPSasameansofevaluating
the performance of a single entity, but
others indicate that EPS represents a
method of making performance comparisons across firms. It is clear that
EPS is a performance measure for a
single company that can be evaluated
overtime.Thequestioniswhetheritis
alsoalegitimatemeansofmakingperformancecomparisonsamongentities.
Researchers in most prior studies on
the usefulness of EPS examined the
effectsofthecomplicatedcomputational
procedures underAPB Opinion No. 15
(e.g., Boyer & Gibson, 1979; Curatola,
Vicknair, &Ward, 1988; Dudley, 1985;
Gaummitz & Thompson, 1987; Mautz
& Hogan, 1989). No researchers evalu344
JournalofEducationforBusiness
atedtheabilityofEPStoallowcomparisonsamongfirms.DeBergandMurdoch
(1994) noted that financial statement
usersoftencomparedfirmsonthebasisof
theirP/Eratios.Asmentionedpreviously,
such comparisons are possible because
P/E ratios represent market-based rankingsofthevalueoffirms’sharesrelative
to their earnings.Although they offered
no empirical proof, DeBerg and MurdochstatedthatEPSaloneshouldnotbe
usedtorankfirmsbecauseitdependson
thenumberofcommonsharesoutstanding for each company: as such, EPS
amounts of different companies are not
readilycomparable.
Theheartoftheissueiswhetherthe
number of common shares outstanding represents an appropriate scaling
measure for company size. If so, EPS
comparisons among firms would be
logical. If not, however, EPS comparisonsamongentitieswouldbemeaningless. A simple example demonstrates
thepotentialdangerofusingEPSalone
toevaluatetheperformanceofdifferent
companies.Intheir2005earningsstatements,Wal-MartandIBMreportednet
incomesof$11.23billionand$7.99billion, respectively (U.S. Securities and
Exchange Commission [SEC], 2006).
Which company was more profitable
in2005?Theanswertothisquestionis
unclear unless one scales the earnings
for firm size. Although both are very
large entities, they are not exactly the
same size: Wal-Mart’s 2005 year-end
assets exceeded $138 billion, whereas
IBM’s assets totaled about $106 billion (SEC). Scaling the firms’ profits
bytotalassetsresultedinWal-Martand
IBMprovidingreturnsoninvestmentin
2005of8.14%and7.54%,respectively.
Thus, using this performance measure,
bothcompanieswerequiteprofitablein
2005,withWal-Martonlyslightlymore
sothanIBM.
However, using EPS as a performance measure paints a markedly differentpictureofprofitability:Wal-Mart
and IBM reported 2005 EPS figures
of $2.68 and $4.99, respectively (SEC,
2006). Comparing EPS for the firms
leadsonetobelievethatIBMwas86%
more profitable than Wal-Mart when
the earlier analysis revealed that the
two companies earned very similar
returns in 2005. The EPS discrepancy
lies in the number of common shares
outstanding. With approximately 4.19
billion shares,Wal-Mart’s denominator
fortheEPScalculationfarexceedsthe
1.6 billion shares for IBM (SEC). For
these two companies, the number of
sharesoutstandingrepresentsamisleading base with which to scale earnings
for comparison purposes. In asset size,
Wal-Mart is only 1.3 times as large as
IBM,althoughithas2.6timesasmany
commonsharesoutstanding.
The analysis of Wal-Mart and IBM
demonstrates the potential pitfall of
comparing performance between firms
usingEPS.Notallcomparisonsamong
entities would result in such drastic
effectsbecausethenumberofcommon
sharesoutstandingacrossabroadspectrumofcompanieswouldprovidesome
measureofentitysize.Intheremainder
ofthisarticle,wedeterminewhetherthe
number of common shares outstanding
isanacceptablescalingmeasureoffirm
sizetoevaluatethelegitimacyofmaking performance comparisons among
firmsusingEPS.
METHOD
To decide if the number of common
sharesoutstandingrepresentsareasonable measure of company size and a
legitimate way to scale earnings, we
collected data on 300 publicly traded
companies. We randomly chose 100
companies from each of 3 size groupings on the basis of market capitalization (i.e., large cap firms with capitalization exceeding $10 billion, medium
cap firms with capitalization between
$1 billion and $10 billion, and small
cap firms with capitalization less than
$1billion).Thisselectionprocessguaranteedthatfirmsofallsizeswererepresentedinthesample.Foreachcompany,
wecollectednumerousvariablesforthe
most recent year end (i.e., typically
2005)frominformationavailableonthe
LexisNexisBusinessdatabase.
The variables included numerous
alternativemeasuresofcompanysize,
such as sales, total assets, number
of employees, and number of commonsharesoutstanding.Weexamined
several proxies of firm size because
previous researchers (Al-Khazali &
Zoubi, 2005) demonstrated that mea-
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sures of entity size are not the same
acrossdifferenteconomicsectors.For
example,totalassetsmaybeareliable
measure of size for large firms but a
less reliable gauge for small companies because small firms often tend
tobetechnologybasedwithfewhard
assets; for them, sales revenue may
beamoreappropriatemeasureofsize
thanareassets.
Ourpurposeinthisstudywastodetermine if the number of common shares
appearstobearelevantmeasureoffirm
size.Tomakethisevaluation,weexamined the strength of relation between
shares outstanding and the other more
readilyacceptedmeasuresofentitysize
using correlation coefficients and simple regression models. A strong relationbetweensharesoutstandingandthe
othermeasuresofsizesuggeststhatthe
number of shares is a good proxy for
firm size, whereas a weak relationship
indicatesitisnot.
Tomaketheanalysismoremeaningful, we divided the sample of firms
into two subsamples on the basis of
companysizebecausesignificantprior
research suggest that the financial
characteristicsoflargeandsmallfirms
differ.Forexample,LieandLie(2002)
demonstrated that the accuracy and
bias of company valuation estimates
varied greatly by company size. Huff
andHarper(1999)foundthatsolvency
and liquidity ratios differed markedly
between large and small firms. Zhao
yang,Chi-Wen,andRosett(2005)concluded that the variability of accountingaccrualsisrelatedtofirmsize.Hall
andWeiss (1967) indicated that profit
rates were related to entity size with
larger firms generally experiencing
higher profit rates. Pomfret and Shapiro (1980) similarly noted that profit
stability is positively correlated with
companysize.Becauselargeandsmall
firms differ drastically in their financialcharacteristics,wesplitthesample
of 300 firms into two groups on the
basis of total assets as the measure of
companysize.Themediantotalassets
for the entire sample is $1.03 billion.
The 150 firms with assets exceeding
this amount comprise the subsample
of large firms, and the 150 firms with
assetsbelow$1.03billionmakeupthe
small-firmgroup.
RESULTS
Table 1 provides summary measures for return on sales and EPS for
the two groups of firms segregated by
size. We analyzed medians rather than
means because means can be unduly
influenced by a few extreme values.
Mediansaremuchlessaffectedbyoutlying values and are often considered
morerepresentativeofagroupthanare
means. Table 1 also presents the first
andthirdquartiles.Twocommonratios
measuring profitability are return on
investment(i.e.,netincomedividedby
totalassets)andreturnonsales(i.e.,net
income divided by sales). Both measureseffectivelynormalizeearningsfor
the size of a company and allow earnings comparisons among different size
firms. However, because total assets
segregatethesamples,returnoninvestmentwouldbebiasedtowardthegroup
of small companies. Ceteris paribus,
a company with a smaller asset base,
wouldbeexpectedtoproduceahigher
returnoninvestmentthanwouldacompany with a larger asset base. For this
reason,wechosereturnonsales(ROS),
orprofitmargin,toscaleprofitability.
Aspriorresearcherssuggested,Table
1 shows that the large firms in general
are more profitable than are the small
entities.ThemedianROSpercentagesfor
thegroupsoflargeandsmallfirmswere
6.88% and 5.70%, respectively. However, using a cutoff alpha level of .01,
thesemediansdidnotdifferatastatisticallysignificantlevel(i.e.,thealphalevel
for comparing the medians was .025).
UsingEPSasameasureofearningsperformance suggested that the large firms
were much more profitable than were
their smaller counterparts. The median
EPS for the large firms of $2.10 was
almost2.5timesthesmallfirms’median
EPSof$0.85.Thesemediansdifferedat
astatisticallysignificantlevel(α=.000).
IfEPSrepresentedalegitimatemeasure
ofearningsscaledforcompanysize,then
thecomparisonofEPSbetweenthelarge
and small firms should have followed a
patternsimilartothecomparisonofROS
forthetwogroups.Thiswasnotthecase.
TheROSmedianssuggestedthatonlya
slight difference in profitability existed
betweenthetwogroupswhereastheEPS
medians indicated a huge difference in
profitabilitybetweenthelargeandsmall
firms.Thisfindingquestionstheusefulness of EPS as a means of comparing
earningsamongfirms.
Anothermethodtodeterminewhether the number of common shares outstanding is a suitable measure of firm
size is to examine the strength of relationbetweenthenumberofsharesand
other more accepted measures of firm
size. As Al-Khazali and Zoubi (2005)
noted,thereisnoonevariablethatbest
capturesfirmsizeforalleconomicsectors or types of firms. For this reason,
weexaminedseveralmeasuresofentity
size. Table 2 and Table 3 provide correlationmatrixesforthegroupsoflarge
andsmallfirms,respectively,andreport
the coefficients for sales revenue, total
assets,numberofemployees,andnumberofcommonsharesoutstanding.
It is not surprising that the more traditionalmeasuresoffirmsize,sales,and
total assets exhibited strong coefficients
for both the large and small firm groups
(i.e., .7131 and .6402 for the large and
small entities, respectively). Even the
number of employees, a much less frequentlyusedscalingmeasureforcompanysize,showedmoderate-to-strongrelationwiththetraditionalmeasuresofsize
(i.e.,salesandtotalassets)forbothgroups
of firms. For example, the coefficients
betweennumberofemployeesandsales
for the groups of large and small firms
were.7950and.5640,respectively.
If the number of shares represents a
legitimatemeasureoffirmsize,thenit,
too, should possess a relatively strong
correlation with the other measures of
size.Thecoefficientsonthebottomrow
of each matrix reveals these relationships. For the large firms, coefficients
between the number of shares and the
otherthreemeasuresoffirmsizeallsuggest a strong correlation. For example,
thecoefficientbetweensharesandsales
of.8311clearlyindicatesthatthenumber of shares is highly related to sales,
an often-used measure of firm size.As
such, the number of shares is a valid
proxy for company size. For the small
firms, however, very weak correlations
existbetweenthenumberofsharesand
theothermeasuresofsize.Forexample,
thecoefficientbetweensharesandsales
of.1383suggestsonlyaslightcorrelationsbetweenthenumberofsharesand
July/August2007
345
TABLE1.ReturnonSalesandEarningsPerShare(EPS)forLargeand
SmallFirms
Returnonsales(%)
Variable
Median
75thpercentile
25thpercentile
Earningspershare($)
Largefirms
Smallfirms
Largefirms
Smallfirms
6.88a
11.02
4.45
5.70a
10.51
0.78
2.10b
3.86
1.39
0.85b
1.62
0.04
a
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Aonesamplemediantestrevealedadifferenceinthereturn-on-salesmediansbetweenthelarge
andsmallfirmsatα=.025. bAonesamplemediantestrevealedadifferenceintheearnings-persharemediansbetweenthelargeandsmallfirmsatα=.000.
TABLE2.CorrelationMatrixesforLargeFirms
Variable
Sales
Totalassets
Employees(n)
Shares(n)
Sales
1
.7131
.7950
.8311
Totalassets
Employees(n)
1
.4857
.6381
1
.6838
Shares(n)
1
TABLE3.CorrelationMatrixesforSmallFirms
Variable
Sales
Totalassets
Employees(n)
Shares(n)
Sales
1
.6402
.5640
.1383
Totalassets
1
.4032
.1790
Employees(n)
1
.0139
Shares(n)
isnotrelatedtoanyofthemeasuresof
firm size at a statistically significant
level. For small firms, the number of
sharesisapoorproxyforfirmsizeand,
therefore, an inappropriate means of
scalingearnings.
Itisunclearwhythenumberofshares
isagoodproxyforentitysizeforlarge
firms but not for small ones. However,
it reinforces prior findings (e.g., Huff
&Harper,1999;Zhaoyangetal.,2005)
thatthefinancialcharacteristicsoflarge
and small companies vary. Perhaps the
number of shares is a weak predictor
of firm size for small firms because
littlevariabilityexistsamongthesmall
entities in relation to shares, at least
whencomparedwiththevariabilityfor
thelargefirms.Forexample,themean
numberofsharesforthegroupofsmall
firms is 41.4 million, with a standard
deviation approximately 1.5 times the
sizeofthemean.Themeannumberof
shares for the large firms is 311.2 million, with a standard deviation about 3
timesthesizeofthemean.Thetighter
clustering of the number of shares for
thesmallfirmssuggeststhatsharesvary
littleforsmallfirms,regardlessoftheir
relative size within the group. Future
researchers could investigate why the
number of shares proxies for size for
largebutnotsmallfirms.
1
DISCUSSION
areadilyacceptedmeasureofsize(i.e.,
sales). For small firms, the number of
sharesisapoorproxyforentitysize.
Inadditiontothecorrelationmatrixes,weransimpleregressionmodelsto
determinethestrengthofthestatistical
relationships between the number of
shares and the other measures of firm
size for the groups of large and small
entities.Forbothgroups,Table4presentsseparateregressionmodelswiththe
number of shares regressed on each of
theotherthreemeasuresoffirmsize.
Table4revealsthateachofthethree
regression models for the large firms
produced respectable coefficients of
determination (r2s), ranging from .4071
for total assets to .6908 for sales. More
important, the alpha levels for the F
ratios for all three models indicate that
thenumberofshareswasrelatedtoeach
of the three measures of firm size at a
346
JournalofEducationforBusiness
statisticallysignificantlevel(α=.000for
eachmodel).Forlargefirms,thenumber
ofsharesseemstoprovideagoodproxy
for entity size and, thus, represents a
viablemeasureforscalingearnings.
Table 4 shows that, for the small
entities,thenumberofsharespossessed
weak relationship with the other measures of size. For example, the r2 of
.0191forthesalesmodelindicatesthat
the number of shares explained less
than 2% of the variation in sales. This
pales in comparison to the nearly 70%
ofvariationinsalesexplainedbyshares
forthelargefirms.Thetotalassetsand
employees models for the small firms
produce similarly low r2s. Even more
tellingarethealphalevelsforthemodels’ F ratios.Again using .01 as a cutofflevelforstatisticalsignificance,the
alpha levels for the three models in
Table4revealthatthenumberofshares
TheprofessionalstandardsconcerningEPSstatethatitspurposeistoprovideinformationonthepastoperating
performance of an entity. This information on past performance allows
financialstatementreaderstoattempt
topredictfutureperformanceaswell.
Thestandardsaresilentregardingthe
use of EPS in making comparisons
amongentities.Manyaccountingtextbookauthorsfollowsuitandnotethat
EPSisusefulonlyforevaluatingperformance within a single company.
Several other textbook authors state
that EPS allows intercompany performance comparisons. Failure of the
professional standards to state that
EPS may be used for comparisons
among companies does not necessarily mean that it should not be done,
especially if the number of common
TABLE4.SimpleRegressionModelsforLargeandSmallFirms
Dependent
variable
Downloaded by [Universitas Maritim Raja Ali Haji] at 23:30 11 January 2016
Largefirms
Shares
Shares
Shares
Smallfirms
Shares
Shares
Shares
Independent
variable
Intercept
Xvariable
r 2
F(1,148)
p
Sales
Totalassets
Employees
3780598
4992764
17.33
14.08
67.52
.00
.69
.40
.46
332.86
102.32
130.83
.00
.00
.00
Sales
Totalassets
Employees
474729
349594
2.39
1.16
.77
.00
.01
.03
.00
2.91
4.93
0.03
.09
.02
.86
sharesoutstandingrepresentsaviable
scalingmeasureforfirmsize.
Theresultsofourstudyshowthatthe
numberofsharesproxiesforfirmsizefor
largepubliclytradedcompanies,butnot
forsmallpubliclytradedones.Assuch,
EPS is a viable measure for comparingperformanceonlyamonglargecompanies. These findings have significant
repercussions for teaching EPS in the
classroom.IfEPSistaughtorpresented
as a procedure for comparing earnings
performanceamongfirms,thepresentationshouldcomewithastrictcaveatthat
thisuseappliessolelytolargefirms.Itis
perhapsbetterandcertainlylessconfusingtostudentsifEPSisnotpresentedin
the classroom as a means of evaluating
intercompanyperformance.
NOTE
Dr. Charles E. Jordan teaches financial and
cost accounting. His research focuses on behavioralissuesinfinancialaccounting.
Dr. Stanley J. Clark teaches financial and tax
accountingandisanactivediscussionleaderincontinuingprofessionaleducationseminars.Hisresearch
concentratesonfinancialaccountingissues.
Dr. W. Robert Smith teaches and conducts
research mainly in tax accounting. He recently
spentayearandahalfonsabbaticalworkingwith
KPMGInternationalinbothtaxandaudit.
Parameterestimates
Correspondence concerning this article should
beaddressedtoDr.CharlesE.Jordan,University
of Southern Mississippi, school of accountancy
andinformationsystems,118CollegeDr.#5178,
Hattiesburg,MS39406.
E–mail:charles.jordan@usm.edu
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THERE’S NOTHING MORE
REFRESHING
THAN NEGLECTING OUR NATION’S
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ISSN: 0883-2323 (Print) 1940-3356 (Online) Journal homepage: http://www.tandfonline.com/loi/vjeb20
Should Earnings Per Share (EPS) Be Taught as a
Means of Comparing Intercompany Performance?
Charles E. Jordan , Stanley J. Clark & W. Robert Smith
To cite this article: Charles E. Jordan , Stanley J. Clark & W. Robert Smith (2007) Should
Earnings Per Share (EPS) Be Taught as a Means of Comparing Intercompany Performance?,
Journal of Education for Business, 82:6, 343-348, DOI: 10.3200/JOEB.82.6.343-348
To link to this article: http://dx.doi.org/10.3200/JOEB.82.6.343-348
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ShouldEarningsPerShare(EPS)
BeTaughtasaMeansofComparing
IntercompanyPerformance?
CHARLESE.JORDAN
STANLEYJ.CLARK
W.ROBERTSMITH
UNIVERSITYOFSOUTHERNMISSISSIPPI
HATTIESBURG,MISSISSIPPI
ABSTRACT.Accountingstandardsstate
thatthepurposeofpresentingearningsper
share(EPS)istoprovidefinancialstatementuserswithinformationontheperformanceofasingleentity.Yet,severaltextbookauthorsgofurthertostatethatEPS
canbeusedtomakecomparisonsamong
firms.Inthisarticle,theauthorsshowthat
althoughEPScomparisonsamonglarge
publiclytradedcompaniesmaybeappropriate,suchcomparisonsshouldnotbe
madeamongsmallpubliclytradedfirms
becausethenumberofcommonsharesoutstandingrepresentsapoorscalingmeasure
forentitysize.Assuch,accountingprofessorsshouldrefrainfromteachingEPSasa
toolformakingintercompanyperformance
comparisonsorattheveryleastshould
warnstudentsofthepitfallsofmakingsuch
comparisons.
Keywords:earningspershare,EPS,performancecomparision
Copyright©2007HeldrefPublications
A
ccounting professors often cite
earnings per share (EPS) as
a measure of company performance.
When Wall Street analysts forecast a
firm’s earnings, they are prognosticatingEPS.EPSissignificantbecausethe
market reacts to an entity’s ability to
meet its earnings expectations: falling
short of expected earnings by even a
fewpenniespersharecancauseaprecipitousdropinstockprice.
AsNikolai,Bazley,andJones(2007)
noted, the amount of EPS for a period
andthetrendofEPSforseveralperiods
for an entity represent important measures of success and are also long-run
indicators of cash flows. Although the
current EPS standard (i.e., SFAS No.
128, Earnings Per Share) says little
about the purpose of EPS, previous
standards shed some light on why this
performance measure exists (Financial
Accounting Standards Board, 1997).
TheAccountingPrinciplesBoard(APB;
1966) in Opinion No. 9, Reporting the
ResultsofOperations,statedthat
when presented in conjunction with formalfinancialstatementsforanumberof
periods[EPS]canbeuseful...inevaluating the past operating performance of
a business entity and in a attempting to
form an opinion on its future potential.
(para.30)
In Opinion No. 15, Earnings Per
Share,theAPB(1969)saidEPSshould
“assisttheinvestorinweighingthesig
nificanceofacorporation’scurrentnet
incomeandofchangesinitsnetincome
fromperiodtoperiod”(para.1).
TheAPB’sstatementsshowthatEPS
is significant because it evaluates a
single entity’s performance over time.
EPS was originally a way to analyze
the accomplishments of a single company and not a means to compare the
earnings of multiple firms. Yet, many
textbookauthorshavestrayedfromthe
original intent of EPS; they suggest
thatitallowsperformancecomparisons
among firms. In addition to pointing
out this discrepancy in textbooks on
the purpose of EPS, in this article we
also attempt to empirically answer the
question of whether EPS represents a
valid method of making intercompany
performancecomparisons.
BackgroundandPriorLiterature
As previously discussed in the professionalstandards,educatorsoriginally
presentedEPSasamethodofevaluating
theearningsperformanceandpotential
ofasingleentity.Manyaccountingtextbookauthorshaveremainedtruetothis
originalpurpose.Forexample,Williams
(2000)statedthat“EPSfiguresareused
to evaluate the past operating performanceofabusinessinforminganopinionconcerningitspotential”(p.14.04).
Williams did not mention using EPS
to compare the performance of mulJuly/August2007
343
Downloaded by [Universitas Maritim Raja Ali Haji] at 23:30 11 January 2016
tiple firms. Nikolai et al. (2007) noted
that the price/earnings (P/E) ratio (i.e.,
marketpricepersharedividedbyEPS)
allowed for intercompany comparisons
becauseitrepresentedthevaluethemarketplacesonashareofstockrelativeto
thecompany’searnings.Forexample,a
P/Eratioof15foronecompanyand10
foranothersuggeststhemarketismore
optimistic about the former company’s
futureearningspotential.However,this
comparisonisnotbetweenfirms’EPS,
but rather, the market’s perception, as
reflectedinshareprice,offutureearningspotential.
Several accounting textbook authors
take a different view in explaining the
purpose of EPS. For example, Needles
and Powers (2007) noted that financial
statement readers used EPS “to judge a
company’sperformanceandtocompare
it with the performance of other companies” (p. 623). Spiceland, Sepe, and
Tomassini (2007) suggested that SFAS
No.128ensuredthatrulesforcomputing
andpresentingEPSmaximizedthecomparability of EPS numbers “from one
company to the next” (p. 965). Schroeder,Clark,andCathey(2005)succinctly stated this view of EPS when they
claimed that “analysts, investors, and
creditors frequently look for some way
tocondenseafirm’sperformanceintoa
single figure, some quick and efficient
waytocomparefirms’performance.EPS
servesthispurpose”(p.175).
Thus, a dilemma exists in how professors are teaching EPS to accounting and other business students. Many
textbooks remain true to the original
designofEPSasameansofevaluating
the performance of a single entity, but
others indicate that EPS represents a
method of making performance comparisons across firms. It is clear that
EPS is a performance measure for a
single company that can be evaluated
overtime.Thequestioniswhetheritis
alsoalegitimatemeansofmakingperformancecomparisonsamongentities.
Researchers in most prior studies on
the usefulness of EPS examined the
effectsofthecomplicatedcomputational
procedures underAPB Opinion No. 15
(e.g., Boyer & Gibson, 1979; Curatola,
Vicknair, &Ward, 1988; Dudley, 1985;
Gaummitz & Thompson, 1987; Mautz
& Hogan, 1989). No researchers evalu344
JournalofEducationforBusiness
atedtheabilityofEPStoallowcomparisonsamongfirms.DeBergandMurdoch
(1994) noted that financial statement
usersoftencomparedfirmsonthebasisof
theirP/Eratios.Asmentionedpreviously,
such comparisons are possible because
P/E ratios represent market-based rankingsofthevalueoffirms’sharesrelative
to their earnings.Although they offered
no empirical proof, DeBerg and MurdochstatedthatEPSaloneshouldnotbe
usedtorankfirmsbecauseitdependson
thenumberofcommonsharesoutstanding for each company: as such, EPS
amounts of different companies are not
readilycomparable.
Theheartoftheissueiswhetherthe
number of common shares outstanding represents an appropriate scaling
measure for company size. If so, EPS
comparisons among firms would be
logical. If not, however, EPS comparisonsamongentitieswouldbemeaningless. A simple example demonstrates
thepotentialdangerofusingEPSalone
toevaluatetheperformanceofdifferent
companies.Intheir2005earningsstatements,Wal-MartandIBMreportednet
incomesof$11.23billionand$7.99billion, respectively (U.S. Securities and
Exchange Commission [SEC], 2006).
Which company was more profitable
in2005?Theanswertothisquestionis
unclear unless one scales the earnings
for firm size. Although both are very
large entities, they are not exactly the
same size: Wal-Mart’s 2005 year-end
assets exceeded $138 billion, whereas
IBM’s assets totaled about $106 billion (SEC). Scaling the firms’ profits
bytotalassetsresultedinWal-Martand
IBMprovidingreturnsoninvestmentin
2005of8.14%and7.54%,respectively.
Thus, using this performance measure,
bothcompanieswerequiteprofitablein
2005,withWal-Martonlyslightlymore
sothanIBM.
However, using EPS as a performance measure paints a markedly differentpictureofprofitability:Wal-Mart
and IBM reported 2005 EPS figures
of $2.68 and $4.99, respectively (SEC,
2006). Comparing EPS for the firms
leadsonetobelievethatIBMwas86%
more profitable than Wal-Mart when
the earlier analysis revealed that the
two companies earned very similar
returns in 2005. The EPS discrepancy
lies in the number of common shares
outstanding. With approximately 4.19
billion shares,Wal-Mart’s denominator
fortheEPScalculationfarexceedsthe
1.6 billion shares for IBM (SEC). For
these two companies, the number of
sharesoutstandingrepresentsamisleading base with which to scale earnings
for comparison purposes. In asset size,
Wal-Mart is only 1.3 times as large as
IBM,althoughithas2.6timesasmany
commonsharesoutstanding.
The analysis of Wal-Mart and IBM
demonstrates the potential pitfall of
comparing performance between firms
usingEPS.Notallcomparisonsamong
entities would result in such drastic
effectsbecausethenumberofcommon
sharesoutstandingacrossabroadspectrumofcompanieswouldprovidesome
measureofentitysize.Intheremainder
ofthisarticle,wedeterminewhetherthe
number of common shares outstanding
isanacceptablescalingmeasureoffirm
sizetoevaluatethelegitimacyofmaking performance comparisons among
firmsusingEPS.
METHOD
To decide if the number of common
sharesoutstandingrepresentsareasonable measure of company size and a
legitimate way to scale earnings, we
collected data on 300 publicly traded
companies. We randomly chose 100
companies from each of 3 size groupings on the basis of market capitalization (i.e., large cap firms with capitalization exceeding $10 billion, medium
cap firms with capitalization between
$1 billion and $10 billion, and small
cap firms with capitalization less than
$1billion).Thisselectionprocessguaranteedthatfirmsofallsizeswererepresentedinthesample.Foreachcompany,
wecollectednumerousvariablesforthe
most recent year end (i.e., typically
2005)frominformationavailableonthe
LexisNexisBusinessdatabase.
The variables included numerous
alternativemeasuresofcompanysize,
such as sales, total assets, number
of employees, and number of commonsharesoutstanding.Weexamined
several proxies of firm size because
previous researchers (Al-Khazali &
Zoubi, 2005) demonstrated that mea-
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sures of entity size are not the same
acrossdifferenteconomicsectors.For
example,totalassetsmaybeareliable
measure of size for large firms but a
less reliable gauge for small companies because small firms often tend
tobetechnologybasedwithfewhard
assets; for them, sales revenue may
beamoreappropriatemeasureofsize
thanareassets.
Ourpurposeinthisstudywastodetermine if the number of common shares
appearstobearelevantmeasureoffirm
size.Tomakethisevaluation,weexamined the strength of relation between
shares outstanding and the other more
readilyacceptedmeasuresofentitysize
using correlation coefficients and simple regression models. A strong relationbetweensharesoutstandingandthe
othermeasuresofsizesuggeststhatthe
number of shares is a good proxy for
firm size, whereas a weak relationship
indicatesitisnot.
Tomaketheanalysismoremeaningful, we divided the sample of firms
into two subsamples on the basis of
companysizebecausesignificantprior
research suggest that the financial
characteristicsoflargeandsmallfirms
differ.Forexample,LieandLie(2002)
demonstrated that the accuracy and
bias of company valuation estimates
varied greatly by company size. Huff
andHarper(1999)foundthatsolvency
and liquidity ratios differed markedly
between large and small firms. Zhao
yang,Chi-Wen,andRosett(2005)concluded that the variability of accountingaccrualsisrelatedtofirmsize.Hall
andWeiss (1967) indicated that profit
rates were related to entity size with
larger firms generally experiencing
higher profit rates. Pomfret and Shapiro (1980) similarly noted that profit
stability is positively correlated with
companysize.Becauselargeandsmall
firms differ drastically in their financialcharacteristics,wesplitthesample
of 300 firms into two groups on the
basis of total assets as the measure of
companysize.Themediantotalassets
for the entire sample is $1.03 billion.
The 150 firms with assets exceeding
this amount comprise the subsample
of large firms, and the 150 firms with
assetsbelow$1.03billionmakeupthe
small-firmgroup.
RESULTS
Table 1 provides summary measures for return on sales and EPS for
the two groups of firms segregated by
size. We analyzed medians rather than
means because means can be unduly
influenced by a few extreme values.
Mediansaremuchlessaffectedbyoutlying values and are often considered
morerepresentativeofagroupthanare
means. Table 1 also presents the first
andthirdquartiles.Twocommonratios
measuring profitability are return on
investment(i.e.,netincomedividedby
totalassets)andreturnonsales(i.e.,net
income divided by sales). Both measureseffectivelynormalizeearningsfor
the size of a company and allow earnings comparisons among different size
firms. However, because total assets
segregatethesamples,returnoninvestmentwouldbebiasedtowardthegroup
of small companies. Ceteris paribus,
a company with a smaller asset base,
wouldbeexpectedtoproduceahigher
returnoninvestmentthanwouldacompany with a larger asset base. For this
reason,wechosereturnonsales(ROS),
orprofitmargin,toscaleprofitability.
Aspriorresearcherssuggested,Table
1 shows that the large firms in general
are more profitable than are the small
entities.ThemedianROSpercentagesfor
thegroupsoflargeandsmallfirmswere
6.88% and 5.70%, respectively. However, using a cutoff alpha level of .01,
thesemediansdidnotdifferatastatisticallysignificantlevel(i.e.,thealphalevel
for comparing the medians was .025).
UsingEPSasameasureofearningsperformance suggested that the large firms
were much more profitable than were
their smaller counterparts. The median
EPS for the large firms of $2.10 was
almost2.5timesthesmallfirms’median
EPSof$0.85.Thesemediansdifferedat
astatisticallysignificantlevel(α=.000).
IfEPSrepresentedalegitimatemeasure
ofearningsscaledforcompanysize,then
thecomparisonofEPSbetweenthelarge
and small firms should have followed a
patternsimilartothecomparisonofROS
forthetwogroups.Thiswasnotthecase.
TheROSmedianssuggestedthatonlya
slight difference in profitability existed
betweenthetwogroupswhereastheEPS
medians indicated a huge difference in
profitabilitybetweenthelargeandsmall
firms.Thisfindingquestionstheusefulness of EPS as a means of comparing
earningsamongfirms.
Anothermethodtodeterminewhether the number of common shares outstanding is a suitable measure of firm
size is to examine the strength of relationbetweenthenumberofsharesand
other more accepted measures of firm
size. As Al-Khazali and Zoubi (2005)
noted,thereisnoonevariablethatbest
capturesfirmsizeforalleconomicsectors or types of firms. For this reason,
weexaminedseveralmeasuresofentity
size. Table 2 and Table 3 provide correlationmatrixesforthegroupsoflarge
andsmallfirms,respectively,andreport
the coefficients for sales revenue, total
assets,numberofemployees,andnumberofcommonsharesoutstanding.
It is not surprising that the more traditionalmeasuresoffirmsize,sales,and
total assets exhibited strong coefficients
for both the large and small firm groups
(i.e., .7131 and .6402 for the large and
small entities, respectively). Even the
number of employees, a much less frequentlyusedscalingmeasureforcompanysize,showedmoderate-to-strongrelationwiththetraditionalmeasuresofsize
(i.e.,salesandtotalassets)forbothgroups
of firms. For example, the coefficients
betweennumberofemployeesandsales
for the groups of large and small firms
were.7950and.5640,respectively.
If the number of shares represents a
legitimatemeasureoffirmsize,thenit,
too, should possess a relatively strong
correlation with the other measures of
size.Thecoefficientsonthebottomrow
of each matrix reveals these relationships. For the large firms, coefficients
between the number of shares and the
otherthreemeasuresoffirmsizeallsuggest a strong correlation. For example,
thecoefficientbetweensharesandsales
of.8311clearlyindicatesthatthenumber of shares is highly related to sales,
an often-used measure of firm size.As
such, the number of shares is a valid
proxy for company size. For the small
firms, however, very weak correlations
existbetweenthenumberofsharesand
theothermeasuresofsize.Forexample,
thecoefficientbetweensharesandsales
of.1383suggestsonlyaslightcorrelationsbetweenthenumberofsharesand
July/August2007
345
TABLE1.ReturnonSalesandEarningsPerShare(EPS)forLargeand
SmallFirms
Returnonsales(%)
Variable
Median
75thpercentile
25thpercentile
Earningspershare($)
Largefirms
Smallfirms
Largefirms
Smallfirms
6.88a
11.02
4.45
5.70a
10.51
0.78
2.10b
3.86
1.39
0.85b
1.62
0.04
a
Downloaded by [Universitas Maritim Raja Ali Haji] at 23:30 11 January 2016
Aonesamplemediantestrevealedadifferenceinthereturn-on-salesmediansbetweenthelarge
andsmallfirmsatα=.025. bAonesamplemediantestrevealedadifferenceintheearnings-persharemediansbetweenthelargeandsmallfirmsatα=.000.
TABLE2.CorrelationMatrixesforLargeFirms
Variable
Sales
Totalassets
Employees(n)
Shares(n)
Sales
1
.7131
.7950
.8311
Totalassets
Employees(n)
1
.4857
.6381
1
.6838
Shares(n)
1
TABLE3.CorrelationMatrixesforSmallFirms
Variable
Sales
Totalassets
Employees(n)
Shares(n)
Sales
1
.6402
.5640
.1383
Totalassets
1
.4032
.1790
Employees(n)
1
.0139
Shares(n)
isnotrelatedtoanyofthemeasuresof
firm size at a statistically significant
level. For small firms, the number of
sharesisapoorproxyforfirmsizeand,
therefore, an inappropriate means of
scalingearnings.
Itisunclearwhythenumberofshares
isagoodproxyforentitysizeforlarge
firms but not for small ones. However,
it reinforces prior findings (e.g., Huff
&Harper,1999;Zhaoyangetal.,2005)
thatthefinancialcharacteristicsoflarge
and small companies vary. Perhaps the
number of shares is a weak predictor
of firm size for small firms because
littlevariabilityexistsamongthesmall
entities in relation to shares, at least
whencomparedwiththevariabilityfor
thelargefirms.Forexample,themean
numberofsharesforthegroupofsmall
firms is 41.4 million, with a standard
deviation approximately 1.5 times the
sizeofthemean.Themeannumberof
shares for the large firms is 311.2 million, with a standard deviation about 3
timesthesizeofthemean.Thetighter
clustering of the number of shares for
thesmallfirmssuggeststhatsharesvary
littleforsmallfirms,regardlessoftheir
relative size within the group. Future
researchers could investigate why the
number of shares proxies for size for
largebutnotsmallfirms.
1
DISCUSSION
areadilyacceptedmeasureofsize(i.e.,
sales). For small firms, the number of
sharesisapoorproxyforentitysize.
Inadditiontothecorrelationmatrixes,weransimpleregressionmodelsto
determinethestrengthofthestatistical
relationships between the number of
shares and the other measures of firm
size for the groups of large and small
entities.Forbothgroups,Table4presentsseparateregressionmodelswiththe
number of shares regressed on each of
theotherthreemeasuresoffirmsize.
Table4revealsthateachofthethree
regression models for the large firms
produced respectable coefficients of
determination (r2s), ranging from .4071
for total assets to .6908 for sales. More
important, the alpha levels for the F
ratios for all three models indicate that
thenumberofshareswasrelatedtoeach
of the three measures of firm size at a
346
JournalofEducationforBusiness
statisticallysignificantlevel(α=.000for
eachmodel).Forlargefirms,thenumber
ofsharesseemstoprovideagoodproxy
for entity size and, thus, represents a
viablemeasureforscalingearnings.
Table 4 shows that, for the small
entities,thenumberofsharespossessed
weak relationship with the other measures of size. For example, the r2 of
.0191forthesalesmodelindicatesthat
the number of shares explained less
than 2% of the variation in sales. This
pales in comparison to the nearly 70%
ofvariationinsalesexplainedbyshares
forthelargefirms.Thetotalassetsand
employees models for the small firms
produce similarly low r2s. Even more
tellingarethealphalevelsforthemodels’ F ratios.Again using .01 as a cutofflevelforstatisticalsignificance,the
alpha levels for the three models in
Table4revealthatthenumberofshares
TheprofessionalstandardsconcerningEPSstatethatitspurposeistoprovideinformationonthepastoperating
performance of an entity. This information on past performance allows
financialstatementreaderstoattempt
topredictfutureperformanceaswell.
Thestandardsaresilentregardingthe
use of EPS in making comparisons
amongentities.Manyaccountingtextbookauthorsfollowsuitandnotethat
EPSisusefulonlyforevaluatingperformance within a single company.
Several other textbook authors state
that EPS allows intercompany performance comparisons. Failure of the
professional standards to state that
EPS may be used for comparisons
among companies does not necessarily mean that it should not be done,
especially if the number of common
TABLE4.SimpleRegressionModelsforLargeandSmallFirms
Dependent
variable
Downloaded by [Universitas Maritim Raja Ali Haji] at 23:30 11 January 2016
Largefirms
Shares
Shares
Shares
Smallfirms
Shares
Shares
Shares
Independent
variable
Intercept
Xvariable
r 2
F(1,148)
p
Sales
Totalassets
Employees
3780598
4992764
17.33
14.08
67.52
.00
.69
.40
.46
332.86
102.32
130.83
.00
.00
.00
Sales
Totalassets
Employees
474729
349594
2.39
1.16
.77
.00
.01
.03
.00
2.91
4.93
0.03
.09
.02
.86
sharesoutstandingrepresentsaviable
scalingmeasureforfirmsize.
Theresultsofourstudyshowthatthe
numberofsharesproxiesforfirmsizefor
largepubliclytradedcompanies,butnot
forsmallpubliclytradedones.Assuch,
EPS is a viable measure for comparingperformanceonlyamonglargecompanies. These findings have significant
repercussions for teaching EPS in the
classroom.IfEPSistaughtorpresented
as a procedure for comparing earnings
performanceamongfirms,thepresentationshouldcomewithastrictcaveatthat
thisuseappliessolelytolargefirms.Itis
perhapsbetterandcertainlylessconfusingtostudentsifEPSisnotpresentedin
the classroom as a means of evaluating
intercompanyperformance.
NOTE
Dr. Charles E. Jordan teaches financial and
cost accounting. His research focuses on behavioralissuesinfinancialaccounting.
Dr. Stanley J. Clark teaches financial and tax
accountingandisanactivediscussionleaderincontinuingprofessionaleducationseminars.Hisresearch
concentratesonfinancialaccountingissues.
Dr. W. Robert Smith teaches and conducts
research mainly in tax accounting. He recently
spentayearandahalfonsabbaticalworkingwith
KPMGInternationalinbothtaxandaudit.
Parameterestimates
Correspondence concerning this article should
beaddressedtoDr.CharlesE.Jordan,University
of Southern Mississippi, school of accountancy
andinformationsystems,118CollegeDr.#5178,
Hattiesburg,MS39406.
E–mail:charles.jordan@usm.edu
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