Negative EPS | How bad is it for a company?

The earnings of any company are just the after-tax net income. In plain English, the EPS is what is left after deducting all costs of the company. So, the earnings per share ratio (EPS) is the total earnings divided by the number of outstanding shares. It is used to measure the success of management in achieving profit for the company’s owners in the last twelve months (this does not mean that all the quarters were negative, just that the total number was lower than zero).

The higher the value of EPS, the greater the profit and the possibility of increasing the dividends received by the shareholders.

There is no rule of thumb for the correct number, but the EPS is typically considered good when a corporation’s profits outperform those in the same sector.

The most intuitive interpretation is that the company is losing money (a fact) and may be facing some problems, but there is often more than that. We need to understand the “Why?”:

Is the company in a high investment phase? Since EPS is related to a single period, is it only a one-time off event (e.g., Covid-19)? Or, on the other hand, does it reveal a company that is on borrowed time? These are the types of questions any retail and professional investor should ask to assess what each EPS number means appropriately.

For example, it is pretty standard for technological and pharmaceutical companies to display negative earnings per share due to heavy investments in research and development, marketing,… The short-term impact is unfavourable but, in the long run, it may present extraordinary results. Indeed, the management teams may have an incentive to focus on short-term results due to, for example, options expiring in a small timeframe and not wanting to have its company shares drop in value. That’s why some investors defend more spaced financial statement release dates.

Look at the example of vaccines for Covid-19. Companies such as Johnson & Johnson, AstraZeneca, Pfizer, among others, have spent massive amounts of money trying to create the vaccines quickly. It may not necessarily lead to negative EPS because they have other areas of business activity, but it will certainly temporarily impact the financial strength of those companies. However, corporations that spend millions on research and do not find the “cure” may face financial constraints in the future.

On the technological side, we may use DraftKings as an example. The US company has invested tremendously in marketing expenses (customer acquisition) during the 4ºQ of 2020, which intensified their negative EPS from previous quarters. Nonetheless, it saw a massive jump in revenues and users, which could create a competitive advantage in the future.

Moreover, a company can present a negative EPS because of a change in accounting norms or a few unexpected occurrences. In such scenarios, you should investigate further to conclude how impactful the change will be on the company’s future.

In summary, some reasons for negative EPS include:

• Struggling business: The corporation may be genuinely facing structural problems leading to consistent destruction of value. This company has a high chance of bankruptcy.
• Sector characteristics: It is very common for specific sectors, as mentioned above, to show high expenses at an early stage of the business or a particular project. Most of the time, it is a work in progress that is expected to bear fruit on a future date.
• Growth companies: Many companies with strong revenue growth are unprofitable (investment phase). But investors still invest because they are growing fast and may become profitable in the future.
• Change in accounting: Changes in accounting methods can sometimes cause EPS to go negative for a short period, even if the company didn’t lose any money.
• One-time effects: During 2020, the COVID-19 crisis hit almost every business. Investors know that it is a unique period, not representing regular activity. So, a negative EPS will definitely occur in companies with positive EPS in the last several years.

All in all, negative EPS does not automatically equate to a “badly managed company”. If you are a beginner, you will sleep better by investing in companies with positive, sustainable profits, so staying away from non-profit corporations may be a good idea.

A good way to see whether negative earnings are caused by accounting, for instance, is to look at the cash flow statement. This can tell you if the company is spending more cash than they take in or if the negative earnings were due to some accounting rules. Also, looking at a company’s revenue growth rate and margin trends might be a reasonable approach to know if it is on a “path to profitability”.

Finally, it would be best if you never decided on whether or not to invest in any company based solely on a single fundamental ratio. Other fundamental data points (Enterprise value, EBITDA, ROCE, Debt,…) are as relevant to assessing a potential investment’s relative attractiveness. So, it is quite prudent to keep each value in context.

Let us know in the comments below the companies that you know are struggling with negative EPS values, and share your thoughts on why that might be happening! 💭💭

Happy investments!