Estimating the Expected EPS & Cash Flow per Share

1. Estimating the Expected EPS

Based on how the company has done in the past, how it is faring currently, and how it is likely to do in future, the investment analyst estimates the future (expected ) EPS. An estimate of EPS is an educated guesses about the future profitability of the company. A good estimate is based on a careful projection of revenues and costs. Analysts listen to what customers say about the products and services of the company, talk to competitors and suppliers, and interview management to understand the evolving prospects of the company.

As an illustration, the expected EPS for Horizon Limited for the year 20x8 is developed:

20x7 (Actual)***20x8 (Projected)***Assumption
Net sales
840***924***Increase by 10%
Cost of goods sold
638***708***Increase by 11%
Gross profit
202***216
Operating expenses
74***81***Increase by 9.5%
Depreciation
30***34
S&GA expenses
44***47
Operating profit
128***135
Non-operating surplus/deficit
2***2***No change
Profit before interest and tax (PBIT)
130***137
Interest
25***24***Decrease by 4%
Profit before tax
105***113
Tax
35***38***Increase by 8.57%
Profit after tax
70***75
Number of equity shares
15 m *** 15 m
EPS
4.67***5.00

Note that the EPS forecast is based on a number of assumptions about the behaviour of revenues and costs. So the reliability of the EPS forecast hinges critically on how realistic are these assumptions.

As an investor when you look at an earnings forecast, examine the assumptions underlying the forecast. What assumptions has the analyst made for demand growth, market share, raw material prices, import duties, product prices, interest rates, asset turnover, and income tax rate? Based on this assessment you can decide how optimistic or pessimistic is the earnings forecast.

It is better to work with a range rather than a single number. Paint few scenarios - optimistic, pessimistic, and normal - and examine what is likely to happen to the company under these circumstances.

2. Estimating the Cash Flow per Share

In addition to the EPS, the cash flow per share which is defined as:

= (Profit After Tax + Depreciation and other non-cash charges)/Number of outstanding equity shares

is also estimated. The cash flow per share in the above illustration is (75+34)/15 = 7.27. The rationale for using the cash flow per share is that the depreciation charge in the books is merely an accounting adjustment, devoid of economic meaning. Well managed companies, it may be argued, maintain plant and equipment in excellent condition through periodic repairs, overhauling and conditioning. As the expenses relating to these are already reflected in manufacturing costs, one can ignore the book depreciation charge. (This argument, however, may not be valid for all companies. So, you must look into the specific circumstances of the company to judge what adjustments may be appropriate).