Introduction to Earnings per Share
The earnings per share (EPS) ratio were considered in Chapter 8 and we may recall that it is calculated as follows:
EARNINGS PER SHARE = Earnings available to ordinary shareholders/ Number of ordinary shares in issue
When used as a basis for directors' incentive plans, a particular level of growth in earnings per share is usually required in order to trigger rewards.
EPS poses problems when used as a performance target for rewarding directors. A major difficulty is that an increase in EPS does not necessarily lead to an increase in shareholder wealth. EPS may be increased by embarking on risky ventures and an increased level of risk may be reflected in a decrease in share price. A further difficulty is that EPS can be increased in the short term by simply changing certain decisions and policies.
An annual EPS target would be inappropriate where a company is suffering losses, caused perhaps by uncontrollable changes in economic conditions. It may take time to turn around the fortunes of company. The directors may have to take tough decisions and work hard over many years before there is any real prospect of generating a profit.
Other accounting ratios
In practice, other ratios based on profits, such as return on capital employed and return on shareholders' funds, may be used to reward executive directors. They suffer, however, from the same sort of problems that afflict EPS.
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