Although earnings per share is a very popular performance measurement tool, it is not without its drawback and limitations. Here are four important drawbacks you should know for your IAS 33 EPS studies.
- Management knows investors rely on using EPS as a guidance for company performance so they’ll naturally want the EPS figure to appear as high as possible in the short term. They may make decisions to maximise the EPS figure in the short term, which may damage the entity’s prospects in the long term.
- EPS also doesn’t consider cash flow. Management may focus so much on increasing the earnings figure, they start selling to bad customers who don’t pay or sell at lower margins. If the company can’t earn cash to pay its bills, no matter how large the earnings are, it may be insolvent.
- EPS also ignores inflation, the price of goods and services generally may be increasing, so this could be contributing to the good EPS figure, but this growth might be misleading if the company can’t buy as many goods this year as it could last year.
- Also, each company has different accounting policies; this makes it harder to compare individual companies on a like for like basis.