The Myth of EPS Growth

The myth of EPS growth

Impact of Retained earnings on EPS
When EPS growth is entirely due to profits from retained earnings, the increased EPS percentage measures the impact of ROE on those retained earnings.

For instance,
Half of profit is retained: If ROE is 20 percent, half the profit is retained and ROE in the following year remains steady at 20 percent, EPS will increase by 10 percent.
All profit is retained: If all profit is retained and reinvested at 20 percent, EPS will increase by 20 per cent.
All profit is distributed: If all profit were distributed, irrespective of ROE, EPS growth would be zero.


Impact of borrowings (debt) on EPS
Increasing borrowings (debt) on EPS: However, even if all profits were distributed as dividends and the business increased its borrowings, EPS would increase. So an increase in EPS might simply signify an increase in debt.
Decreasing borrowings (debt) on EPS: Conversely, if borrowings were reduced and ROFE exceeded the cost of debt, EPS would decline.


Impact of new capital issues on EPS
When equity per share increases by virtue of new capital issues that exceed the current equity per share, EPS can increase when the business performance (ROE) declines.

So the positive news of an increase in EPS might disguise the fact that value has declined by virtue of diminished profitability.

Because management seems to be as equally ignorant of this factor as the market, focusing on EPS growth can make bad capital-allocation (acquisitions) decisions appear beneficial.

When new shares are issued at a price that exceeds the book value of equity per share, the EPS of a company with a modest business performance can increase quite dramatically.

For instance, a company with a ROE of 10 per cent, $500 million equity and 100 million shares on issue will have an EPS of $0.50 on its equity of $5.00 per share. Given a P/E ratio of 15, the $5.00 equity per share will be priced at $7.50 ($0.50 x 15).

New shares are issued at a price > the book value of equity per share: If the company issues a further 100 million shares at its market price of $7.50, raising $750 million, the 200 million shares on issue will have an equity of $1.25 billion or $6.25 per share.

If the modest ROE of 10 percent is maintained on the increased capital, EPS will grow by 25 percent. That is: equity $1.25 billion / 10% = $125 million / 200 million shares = EPS of 62.5c.

If the P/E ratio of 15 is maintained, the shares will now be priced at 62.5c x 15 = $9.36.

New shareholders whose generosity increased the original shareholders’ equity by 25 per cent to $6.25 a share, having paid $7.50 for stock now priced at $9.36, will be under the impression they made a sound investment decision.

When a company regularly issues shares at prices that exceed the current equity per share, the false impressions of EPS growth will give support and impetus to its share price.

New shares are issued at a price = the book value of equity per share: If the new shares had been issued with the $5.00 equity per share, a price that is closer to the value, EPS would have remained unchanged and EPS growth would be zero.

Does this mean that the lack of EPS growth diminishes the value of the business? Of course not, it is still the same business.

New shares issued at a price > the book value of equity per share, but the ROE declines: When new capital issues are made at prices that exceed the equity per share, EPS will not necessarily decline when the business performance declines. If ROE declined to 8 percent in the example given, EPS will be unchanged: equity $6.25 x ROE 8 percent = EPS 50c.

Conclusion:

The coloured bar charts of profit, dividends and EPS growth in an annual report, although correctly stated, can give an entirely misleading impression. The ever-increasing height of the EPS, profit and dividend columns in the bar chart have nothing whatsoever to do with the business performance.

Because both management and market participants fail to recognise the importance of ROE and ROFE, you are unlikely to ever see them depicted by way of a bar chart in the annual report, or for that matter in an analyst’s research. If you do, take a good look at the company because the CEO is likely to be one of that rare breed who truly understands the impact of capital-allocation decisions.

Using Charlie Munger’s terminology, such a CEO can be likened to a two-legged man competing with one-legged men in an arse-kicking contest. Much better for management, so the thinking goes, to treat shareholders like fools by depicting graphs that move in continuous upward direction.

So what does EPS growth tell us? Essentially nothing, and it should therefore, be disregarded as another misleading indicator that leads to erratic pricing.