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(Precious) Words of Wisdom : "Wall Street makes its money on ACTIVITY, you make your money on INACTIVITY." ~ Warren Buffett

Don't get conned by "doctored" EPS

Let's be practical. People are 'not' going to read balance sheets before investing. In fact, even if they read them, it will not be easy to get the true picture behind all the obfuscation and trickery resorted to by many companies...especially the unscrupulous ones. All this falls under the domain of the experts.

Hence, my first advice to investors is to leave your equity investment to experts i.e. the mutual funds. They have proven their worth over the last 10-15 years that they have been in this business of managing your money. Besides, SEBI and AMFI have always ensured efficient and transparent functioning of the MF industry.

However, if you are still itching to try your 'luck' — luck because you are not likely to do a thorough study before buying stocks — you can at least take some basic precautions to ensure that you do not become a gullible victim to the sly manipulators.

As we all know, profit...and consequently the EPS (Earnings Per Share)...is a very important number for any equity investor. And this number is very easy to manipulate. Therefore, you would do well to keep the following points in mind when you look at profits or EPS of any company.

1.  One or two year's of 'sudden' improvement in the earnings could be sign of 'fixing' unless backed by solid reasons. 
2.  Ideally, the company should have a long term track record of delivering genuine profits. Consistent dividend payout is a sign of genuine profits as it shows that the company has cash to distribute
3.  Look at 'Diluted' EPS (i.e. after assuming conversion of all ESOPs, convertible debentures etc.) and not just the headline EPS 
4.  In fact, Cash EPS is still better than EPS based on PAT as it is relatively more difficult to manipulate cash than profits
5.  Consider only the audited numbers; proforma numbers could be tampered with
6.  Look for any extraordinary items, change in depreciation method, change in amortization policy, etc. that have a direct impact on the profit number. (Impact of these will get diluted if you take average of at least 3-5 years of profits)       
7.  Future prospects of the business should look good enough for the company to continue making and growing its profits

This (a) may not provide 100% protection against manipulated figures and (b) you may miss some good opportunities. However, the benefits of skipping a whole lot of bad companies will far outweigh these minor drawbacks.   

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