Don't Be Fooled by Earnings Growth

If a company's earnings per share are increasing, it may just be because of the company buying back shares of its stock, and not because of increased performance.

While share buybacks are generally good, as they boost the value of each remaining share of stock, ideally they shouldn't be the only driver of earnings per share (EPS) growth. Also, if a company's stock is trading at too-high levels, then the company is squandering money by buying back shares at inflated levels. Share buybacks should occur at attractive levels.

To see what's going on at a given company, focus on its net income. Share buybacks reduce the number of shares outstanding (because shares bought back are essentially retired). When the number of shares decreases, the earnings per share rise. To get a handle on what's happening without regard to buybacks, just examine the total net income, before it's divided by the number of shares and becomes EPS. And compare that number with EPS.

For example, look at these numbers for AutoZone (NYSE: AZO  ) , for the quarter ending in May in 2003 and 2004:

2004 2003
Net sales $1,360 $1,288
Net income $143 $126
Diluted EPS $1.68 $1.30
Shares* 85 97
(Numbers in millions)
*Diluted shares outstanding

EPS growth is a whopping 29%. But the underlying net income growth is just 13.5% -- admittedly solid, but not eye-popping. Top-line growth, net sales, is just 5.6%. What's going on? Well, the company is wringing growth in profits not so much from sales as from reducing the number of shares outstanding, which dropped by 12% over the year.

In the table above, if you didn't know how many shares outstanding the company had, you could still tell that the number of shares had decreased, since EPS was increasing faster than net income (29% vs. 13.5%).

You can learn more about how to interpret financial statements in our "Crack the Code: Read Financial Statements Like a Pro" How-to Guide. Give it a whirl -- what do you have to lose, except your fear of financial statements?


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