How To Evaluate The Quality Of EPS and find out what it's telling you about a stock.

Examining Earnings Quality

Overview  

The evaluation of earnings per share should be a relatively straightforward process, but thanks to the magic of accounting, it has become a game of smoke and mirrors. This, however, does create opportunities for investors who can evaluate the quality of earnings over the long run and take advantage of market overreactions.

EPS Quality  

High-quality EPS means that the number is a relatively true representation of what the company actually earned (i.e. cash generated).  But while evaluating EPS cuts through a lot of the accounting gimmicks, it does not totally eliminate the risk that the financial statements are misrepresented. While it is becoming harder to manipulate the statement of cash flows, it can still be done.

A low-quality EPS number does not accurately portray what the company earned.  A reported number that does not portray the real earnings of the company can mislead investors into making bad investment decisions. 

How to Evaluate the Quality of EPS

The best way to evaluate quality is to compare operating cash flow per share to reported EPS. While this is an easy calculation to make, the required information is often not provided until months after results are announced, when the company files its 10-K or 10-Q with theSEC.

To determine earnings quality, investors can rely on operating cash flow. 

1.  Positive earnings but negative Operating cash flow.

• The company can show a positive earnings on the income statement while also bearing a negative cash flow. 
• This is not a good situation to be in for a long time, because it means that the company has to borrow money to keep operating. And at some point, the bank will stop lending and want to be repaid. 
• A negative cash flow also indicates that there is a fundamental operating problem: either inventory is not selling or receivables are not getting collected.
• "Cash is king" is one of the few real truisms on Wall Street, and companies that don't generate cash are not around for long.

2.  Operating cash flow > earnings 

• If operating cash flow per share (operating cash flow divided by the number of shares used to calculate EPS) is greater than reported EPS.
• In this case, earnings are of a high quality because the company is generating more cash than is reported on the income statement. 
• Reported (GAAP) earnings, therefore, understate the profitability of the company.

3.  Operating cash flow < earnings

• If operating cash flow per share is less than reported EPS, it means that the company is generating less cash than is represented by reported EPS. 
• In this case, EPS is of low quality because it does not reflect the negative operating results of the company.
• Therefore, it overstates what the true (cash) operating results. 

Trends Are Also Important

Because a negative cash flow may not necessarily be illegitimate, investors should analyze the trend of both reported EPS and operating cash flow per share (or net income and operating cash flow) in relation to industry trends.

• It is possible that an entire industry may generate negative operating cash flow due to cyclical causes.
• Operating cash flows may be negative also because of the company's need to invest in marketing, information systems and R&D. In these cases, the company is sacrificing near-term profitability for longer-term growth.

Evaluating trends will also help you spot the worst-case scenario, which occurs when a company reports increasingly negative operating cash flow and increasing GAAP EPS. 

• As discussed above, there may be legitimate reasons for this discrepancy (economic cycles, the need to invest for future growth), but if the company is to survive, the discrepancy cannot last long. 
• The appearance of growing GAAP EPS even though the company is actually losing money can mislead investors. This is why investors should evaluate the legitimacy of a growing GAAP EPS by analyzing the trend in debt levels, times interest earned, days sales outstanding and inventory turnover.

The Bottom Line

Without question, cash is king on Wall Street, and companies that generate a growing stream of operating cash flow per share are better investments than companies that post increased GAAP EPS growth and negative operating cash flow per share. 

Earnings increasing and Operating cash flow increasing > Earnings increasing but negative operating cash flow

The ideal situation occurs when operating cash flow per share exceeds GAAP EPS. 

Operating cash flow > Earnings

The worst situation occurs when a company is constantly using cash (causing a negative operating cash flow) while showing positive GAAP EPS. 

Positive Earnings but negative operating cash flow.

Luckily, it is relatively easy for investors to evaluate the situation. 

http://www.investopedia.com/articles/analyst/03/091703.asp

An Example
Let's say that Behemoth Software (BS for short) reported that its GAAP EPS was $1. Assume that this number was derived by following GAAP and that management did not fudge its books. And assume further that this number indicates an impressive growth rate of 20%. In most markets, investors would buy this stock.

However, if BS's operating cash flow per share were a negative 50 cents, it would indicate that the company really lost 50 cents of cash per share versus the reported $1. This means that there was a gap of $1.50 between the GAAP EPS and actual cash per share generated by operations. A red flag should alert investors that they need to do more research to determine the cause and duration of the shortfall. The 50 cent negative cash flow per share would have to be financed in some way, such as borrowing from a bank, issuing stock, or selling assets. These activities would be reflected in another section of the cash flow statement.

If BS's operating cash flow per share were $1.50, this would indicate that reported EPS was of high quality because actual cash that BS generated was 50 cents more than was reported under GAAP. A company that can consistently generate growing operating cash flows that are greater than GAAP earnings may be a rarity, but it is generally a very good investment.

Corporate Finance - Earning Growth Rate and Dividend Growth Rate

 Calculating a Company's Implied Dividend Growth Rate

Recall that a company's ROE is equal to a company's earnings growth rate (g) divided by one minus a company's payout rate (p).

Example:Let's assume Newco's ROE is 10% and the company pays out roughly 20% of its earnings in the form of a dividend. What is Newco's expected growth rate in earnings?

Answer:g = ROE*(1 - p)
g = (10%)*(1 - 20%)
g = (10%)*(0.8)
g = 8%

Given an ROE of 10% and a dividend payout of 20%, Newco's expected growth rate in earnings is 8%.

Read more: http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/dividend-growth-changing-dividend-policy-effects.asp#ixzz1yf57n9sb

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.

Investors In Common Stocks Must Get Valuation Right; Here’s How

By Chuck Carnevale

Mar 09, 2012 04:54AM GMT

Chuck Carnevale

 

The investment industry is replete with pundits and self-proclaimed experts espousing various principles and rules that allegedly are the best way to value a stock correctly. Unfortunately, and in most cases, these rules are stated as fact, but unfortunately very few facts are ever presented to back them up.  In other words, much of it is either opinion or gleaned from something they’ve read or been taught before.  But even as a young boy, I was never willing to accept dogma as fact without simultaneously being provided supporting evidence and a logical explanation as to the “why” that they work.

In fifth grade I was once sent to the principal’s office by my English teacher because I made her cry.  She cried because every time she would regurgitate a rule of grammar, punctuation or spelling, she expected me to accept it unconditionally, merely because she said so.  For example, she would say something like I before E except after C expecting me to simply accept this rule as fact. I, on the other hand, not meaning to be argumentative or disruptive, only inquisitive, would immediately raise my hand in class and ask a simple question-why? No matter what rule she would state, I would relentlessly raise my hand and ask okay, but why?  I was not willing to have the rule dictated to me; I needed to understand why it was the rule and why it was important.

Now that I am an adult, I have continued to embrace my inquisitive nature, and to this day I will not accept a dogmatic statement without understanding why.  On the other hand, when I can review supporting evidence that validates the rule and therefore understand its significance, relevance and validity, then and only then, through my understanding it, can I embrace it willingly and passionately.  Therefore, as an author of financial articles, I believe my readers should hold me to this same standard that I hold others to.  Consequently, this article is designed to illuminate the “why” behind widely accepted notions of valuing a business primarily based on earnings (discounting cash flows).

When Investing in a Business Earnings Determine Intrinsic Value

In his best-selling book One Up On Wall Street, famed portfolio manager Peter Lynch dedicated his entire 10th chapter to earnings and thus titled it –Earnings, Earnings, Earnings. In the chapter’s second paragraph he succinctly stated the importance of earnings as follows:

“There are many theories, but to me, it always comes down to earnings and assets.  Especially earnings.  Sometimes it takes years for the stock price to catch up to a company’s value, and the down periods last so long that investors begin to doubt that it will ever happen. But value always wins out-or at least in enough cases that it’s worthwhile to believe it.”

An important foundational principle behind this discussion is the idea that we are talking about investing as part owners of strong businesses, rather than trading stocks.  Business owners are rewarded through the profits the companies they own are capable of generating on their behalf. These rewards can come in the form of salaries and bonuses for active owners, and from increasing value or cash flow from dividends for passive shareholders. In either event, all these rewards are ultimately a function of the businesses’ earnings capability, at least in the longer run.  Therefore, we should realize that when you truly invest in a stock, you really are investing in its ability to earn more money for you in the future.

When I first read Peter Lynch’s famous book in 1990, I had already developed a strong belief in the importance of earnings regarding assessing the fair value of an operating business.  Therefore, the theory behind Peter Lynch’s wisdom already resonated deep within me.  However, as already stated, it was the facts behind the theory that interested me the most. In fact, I was so committed to the notion that earnings determine market price, that I developed my own stock graphing tool that allowed me to evaluate the true relationship between a company’s earnings and its stock price over time.

The following additional quotes from Chapter 10 of Peter Lynch’s book titled: Earnings, Earnings, Earnings, speak to the importance of valuing a business based on its earnings power:

“you can see the importance of earnings on any chart that has an earnings line running alongside the stock price….  On chart after chart the two lines will move in tandem, or if the stock price stays away from the earnings line, sooner or later it will come back to earnings.”

A few pages later, Peter offers us another nugget of wisdom on the earnings and price relationship, plus a little bit of investing advice thrown in:

“a quick way to tell if a stock is overpriced is to compare the price line to the earnings line……. If you bought familiar growth companies…… when the stock price fell well below the earnings line, and sold them when the stock price rose dramatically above it, the chances are you would do pretty well.”


Now that we’ve reviewed some investing axioms and nuggets from Mr. Peter Lynch, let’s see if we can perform two extremely important tasks. 

• First and most importantly, let’s see if we can answer the more important question as to why earnings determine market price; not just that it does. 
• Next, let’s produce some evidence that verifies the veracity of Mr. Peter Lynch’s words. 

In order to accomplish both of these important tasks we will rely on visual representation, and mathematical proofs provided by F.A.S.T. Graphs™. 

How to Value a Company’s Earnings and Why

The essential point underpinning the thesis of this article, is that when you’re investing in a business you’re not actually buying the stock, you’re buying the company’s earnings power.  The stock is only the vessel that contains the earnings you are purchasing.  When buying earnings, the principles of value apply just like they do with any other product or service. The easiest way to understand this clearly, is to think in terms of the price you pay to buy $1 dollar’s worth of one company’s earnings versus $1 dollar’s worth of another company’s earnings.

In other words, let’s look at two companies to see what the price, and therefore, value, of $1 dollar’s worth of earnings are. However, before we do, let’s establish some doctrine that we are going to focus on. First and foremost, remember that we are going to buy $1 dollar’s worth of earnings for each of our two companies.  Now, we need to clearly understand that once either of those dollar’s worth of earnings are taken out of the business and put into our pockets, the value of each dollar’s worth of earnings is precisely the same. When separated from the business, a dollar is a dollar, and a dollar from one company will buy no more or no less than a dollar from another company.

However, we also have to deal with the fact that $1 dollar’s worth of each respective company has a different cost.  This then begs the question, why? 

• In other words, why would we pay more to buy company A’s dollar worth of earnings than we would to buy Company B’s dollar worth of earnings? 
• Since a dollar’s worth of each company’s earnings once received outside of the business is worth exactly the same, why would we pay more to buy one of the dollars than the other?

The reason, as we will develop more fully later, is that if we are long-term investors in businesses, we are actually buying future earnings, not current earnings. Therefore, the amount of earnings we accumulate in the future will be a function of the company’s earnings growth rate, and will determine what price we paid today to buy those future earnings of tomorrow. Let’s clarify this by examining the dynamics of our two example companies. We will start with history presented as evidence of what has actually already happened, and then we will move on to the future, which we believe is actually more relevant.

Our first example is Sherwin-Williams Co. (SHW), which has achieved a historical earnings growth rate of 9.6% since 1999. At the bottom of the graph you can see that earnings have grown from $1.81 per share in 1999, to an estimate of $5.67 per share for fiscal 2012 (see yellow highlighted earnings at the bottom of the graph).  This represents approximately a three-fold increase in earnings over the past 14 years. The primary point is that every $1 dollar’s worth of earnings you bought in 1999, are now worth approximately $3 dollars. Another way to put this is that Sherwin-Williams’ future dollars in 2012 only cost one third as much as the original $1 dollars worth of earnings cost in 1999.

 SHW Chart 1

Our second example, CSX Corp. (CSX), grew earnings per share at the higher rate of 12.9% since calendar year 1999.  Therefore, earnings per share grew from $.26 a share in calendar year 1999 to $1.86 per share estimated for fiscal year-end 2012 (see yellow highlighted earnings at the bottom of the graph). This is approximately a seven-fold increase in earnings per share over this 14-year period. The primary point is that every $1 dollar’s worth of earnings you bought in 1999, are now worth approximately $7 dollars. Consequently, shareholders that bought CSX in 1999 only paid 1/7th of the original price for calendar year 2012 earnings.  In other words, due to the company’s historical earnings growth rate, future earnings were significantly cheaper than original earnings. As we will discover next, herein lays the essence of fair value, or what others call intrinsic value of a business (common stock).

 CSX 1

Now let’s move to current time to examine what price we have to pay to buy $1 dollar’s worth of each of our example company’s earnings today, and attempt to calculate what $1 dollar’s worth of future earnings are actually costing us. The metric that establishes that price is the common PE ratio.  One of the definitions of the PE ratio is: The price you pay to buy $1 dollar’s worth of a company’s earnings.  Remember though, we are pricing $1 dollars worth of today’s earnings, even though in actuality what matters most is the price we’re paying to buy $1 dollars worth of future earnings.

In the case of Sherman-Williams (SHW), today we are asked to pay $20.90 (current PE ratio 20.9 see red circle at right of graph ) to buy our $1 dollar’s worth of current earnings.  As an aside, you can note from the graph that this is the highest valuation or price that you were asked to pay to buy a $1 dollar’s worth of Sherwin-Williams’ earnings since 1999.  In other words, Sherwin-Williams’ stock appears very expensive today based on historical earnings growth.

 SHW 2

In the case of our second example, CSX Corp. we discover that we are only being asked to pay $11.90 (current PE 11.9 see orange circle at right of graph) to buy $1 dollar’s worth of CSX Corp.’s current earnings. This is almost half the price we are being asked to pay to buy an equivalent $1 dollar’s worth of Sherwin-Williams Co.’s earnings. Therefore, the rational investor should ask this simple question:  Why should I be willing to pay almost twice as much to buy Sherwin-Williams’ earnings as I’m being asked to buy CSX’s earnings? The only logical answer would be because future earnings are expected to be much higher for Sherwin-Williams Co. than for CSX Corp. But in fact, this is not true, and as we will next illustrate, the real answer doesn’t make any mathematical sense.

 CSX 2

Utilizing the Estimated Earnings and Return Calculator we discover that the consensus (15 analysts reporting to Capital IQ) estimate earnings growth rate for Sherman-Williams at a very strong 13.1%. This calculates out that expected calendar year 2017 earnings of $10.64 will be approximately twice as large as 2011’s earnings of $4.95.  Therefore, we are, in theory at least, only paying approximately $10 today to buy a future $1 dollar’s worth of Sherwin-Williams’ 2017 earnings.  In other words, the PE ratio of the future earnings we are buying is approximately 10, or half of what we have to today pay for current earnings.

 SHW 3

Once again, utilizing the Estimated Earnings and Return Calculator we discover that the consensus (26 analysts reporting to Capital IQ) expect CSX Corp. to grow earnings at a very strong rate of 14%. This calculates out that CSX Corp.’s expected earnings in 2017 will also be approximately 2 times larger than today’s earnings of $3.63 in 2017 versus the original $1.67 in 2011.  To be clear, this means that the earnings growth rates in both of our sample companies are expected to be essentially the same or at least similar.

Most importantly, it also means that we are only paying a PE of 5.6 to buy CSX Corp.’s $1 dollar’s worth of future earnings (2017) versus paying a PE of 10 for Sherwin-Williams’ $1 dollar’s worth of future earnings (2017). As we’ve previously established, if we received $1 dollar’s worth of dividends from both companies, each would be able to buy no more or no less goods or services than the other.  So once again we ask the question; why would we want to pay twice as much to buy $1 dollar’s worth of Sherwin-Williams’ future earnings as we would to buy CSX Corp.’s? Logically, it makes no sense, yet many investors do it every day.

 CSX 3

In the two examples used in our analogy above, we identified two companies with somewhat similar historical growth rates, but more importantly with almost identical expectations for future growth.  Consequently, logic should dictate that both companies should be priced at approximately the same valuations.  The examples utilized, neither company has a real edge over the other company regarding earnings power. Therefore, why should the one, Sherwin-Williams Corp., have an edge in market price over the other, CSX Corp.? The straightforward answer; there is no rational reason.

It’s also important to recognize that the market does not always price common stocks according to their fair value.  In fact, at any moment in time, the market can be mispricing the value of common stocks by significant degrees.  This is why the venerable Ben Graham gave us his famous metaphor: “in the short run the market is a voting machine, but in the long run it’s a weighing machine.”  This is the same lesson that Peter Lynch offered in the above referenced quote where he talks about value eventually winning out.  Shrewd investors know how to calculate fair value, and therefore, are capable of avoiding what is often the obvious mistake of paying too much.  On the other hand, shrewd investors also recognize a bargain when they see one.
Furthermore, it should also be understood that there are valid reasons to pay more for one company than for another.  However, those reasons have to be mathematically sound and, therefore, make economic and prudent sense.  For example, thanks to the power of compounding; a company with a very high growth rate of 20% to 30% or more would obviously be worth more than a company only growing at 10% or 15%.

• The point is that the faster growing company would be capable of generating significantly more future earnings than the slower growing one.  
• Therefore, even though you pay more today to buy the faster grower, you can actually be buying future earnings cheaper, again, thanks to the power of compounding.

Summary and Conclusions

The moral of the story is simply that investors should be careful and willing to always run the numbers out to their logical conclusions. But, it all starts with knowing what you are buying (investing in) in the first place.  True investors, like Peter Lynch, and many of the other renowned investing greats such as Phil Fischer, Warren Buffett, etc., all invest as owners in businesses with a focus on the strength of the business behind the stocks they buy. Therefore, these investor greats are always buying the earnings power of the respective businesses they are investing in, relative to their goals and objectives.

These principles of valuation apply equally to growth stocks as they do dividend stocks.  When applied to growth stocks,

• investors need to understand that the more future earnings they can buy today at a good price, means more future earnings that the market can capitalize in the future.  
• Since this is their only source of return, the more future earnings they can amass the more value or return they can expect.  
• Fast growth does typically come at a higher price, but simultaneously it needs be understood that faster growth, if it occurs, also generates a bigger pile of future earnings. 
• And, as this article has illustrated, it’s the future earnings that ultimately drive fair value.

When applied to dividend paying stocks, the principle is just as valid, and maybe easier to see.  

• Since the company is going to pay dividends, the dividend investor is going to receive some of the company’s earnings in cash outside of the business.  
• As I illustrated above, when they go to spend $1 dollar’s worth of dividends from Company A versus $1 dollar’s worth of dividends from Company B, each $1 dollar’s worth of dividends will have the same value outside of the business.  
• Therefore, it only logically follows that both of those dollars should have the same value while they are still in the business.

Importantly, a few words on the differences between investing and speculating are perhaps in order. 

Active traders will not find any value in this discussion, because

• active traders usually don’t own a company long enough to think about earnings power at all.  
• Active traders are only really interested in momentum and volatility.  
• They are “the voting machine” segment of the market. 
• This is a primary reason why stocks can become improperly or unrealistically valued by Mr. Market, the voter; however, there are others reasons that we will leave to future discussions. 
• Additionally, to be a trader requires a continuous commitment to watching every little price tick of the market, which is beyond the interest of most people that are investing for their future economic benefit.

True investors are interested in 

• building long-term positions in great businesses bought at rational prices. 
• It is to this segment of the financial community that this article is geared to. 
• Frankly, we believe this is the largest segment of the market comprised of prudent investors that have other things to do with their time than watching the bouncing ball of often frivolous stock price movements.  
• These true investors need to understand the principles of valuation presented in this article if they are going to achieve their financial goals while simultaneously doing so at reasonable levels of risk.

Based on this discussion, of the two companies utilized as examples in this article, the principles of valuation would indicate that one is a buy and one is a sell. We believe that both of these companies are excellent candidates that when appropriately priced (valued) would make great additions to almost any long-term investors portfolio.  However, if the expected future growth rates are accurate, then Sherwin-Williams is clearly overpriced, while CSX Corp. looks like a great bargain today.  Of course, all prospective investors are encouraged to perform their own due diligence before taking any action.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

http://www.forexpros.com/analysis/investors-in-common-stocks-must-get-valuation-right;-here%E2%80%99s-how-116410

WHAT WARREN BUFFETT LOOKS FOR IN COMPANY GROWTH

An investor likes to see a company grow because, if profits grow, so do returns to the investor. The important thing for the investor, however, is that the company increases the returns to shareholders. A company that grows, at the expense of shareholder returns, is not generally a good investment. As Warren Buffett said in 1977:

‘Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5 % increase in earnings per share.’

WARREN BUFFETT AGAIN ON GROWTH

For Warren Buffett the important thing is not that a company grows (he points to the growth in airline business that has not resulted in any real benefits to stockholders) but that returns grow. In 1992, he said this:

‘Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long term market value.

In the case of a low-return business requiring incremental funds, growth hurts the investor.’

Have an opinion on future growth - How can the company increase its earnings?

It is only rational to have an opinion on future growth.  Otherwise, how could you ever choose a stock?

When forming that opinion, back up quantitative information with qualitative factors.

For example, ask what management is doing to make a positive impact on earnings.

According to Peter Lynch, there are 5 basic ways a company can increase earnings:

• reduce costs; 
• raise prices; 
• expand into new markets;
• sell more of its products to the old markets; or
• revitalize, close or otherwise dispose of a losing operation.

When management is enacting growth-promoting activities, earnings may be temporarily flat.  They often soon take a giant step up.

Benjamin Graham saw a vulnerability in a high growth rate and in high returns on capital - the two normally go together.

So what's there to worry about in good earnings?  Exceptionally high earnings often attract rough competitors.  

The good part is that high earnings lure enthusiastic new investors, who often bid the share into the stratosphere.


Comment:
Buy good quality growth companies.
Assess the quality of the business and the management.
Then do the valuation.
These are the basics of the QVM or QMV approach to investing.

High steady ROE and increasing ROE

Many investors, Warren Buffett himself included, get pretty excited when they see steady ROE over a number of years, particularly when already at a high level, say, greater than 15 percent.


Why?


ROE is defined as net earnings divided by owner's equity. What happens to net earnings, each year, in well-managed companies? They become part of owner's equity as retained earnings. Then, over time, the denominator of the ROE equation goes up, as earnings become equity (unless a portion of earnings are paid out as dividends).


That brings the following important observations:

• Maintaining a constant ROE percentage requires steady earnings growth.


• A company with increasing ROE, without undue exposure to debt or leverage, is especially attractive.

On the surface, a steady ROE would appear to indicate a ho-hum business. Same old, smae old, year in and year out. But the truth as illustrated is quite different. One can be excited that the business is growing to stay the same, as evidenced by a high constant ROE. :-)

ROE vs Earnings Growth Rate (EPSGR)

In fact, over time, ROE trends towards the earnings growth rate of the company.

A company with a 5 percent earnings growth rate and a 20 percent ROE today will see ROE gradually diminishing toward 5 percent.


A company with a 20 percent earnings growth rate and a 10 percent ROE will see ROE move toward 20 percent, as the numerator grows faster than the denominator.


Also read:
ROE versus ROTC
****Stock selection for long term investors

Choosing a Discount Assumption

Choosing a discount assumption

In theory, the discount rate should be your own personal cost of capital for this kind of investment. If you have a million dollars and can invest it with no risk in a Treasury bond at 6 percent, your cost of capital is the risk-free 6 percent you would forgo by not investing in the bond. So the implied cost of your dollars made available to invest in Business XYZ starts at 6 percent. Financial types refer to this opportunity cost as the risk-free cost of capital.

But implicitly, Company XYZ common stock is riskier than the bond investment. Sales, earnings, and myriad other intrinsic things can change, as can markets and the market perception of XYZ’s worth. So an equity premium is added to the risk-free cost of capital rate. In effect, the total cost of capital is your required compensation, or hurdle, for the opportunity you’ve lost by not buying the bond, plus the assumption of risk by investing in XYZ.

Much has gone into identifying appropriate risk premiums and the like. Modern portfolio theory and its reliance on beta – a measure of relative stock price volatility – doesn’t really do much for most value investors. (Remember: Price doesn’t determine value.)

The keep-it-simple-safe (KISS) approach used by most value investors, including Warren Buffett, is to discount at a relatively high rate, usually higher than the growth rate. Buffett uses 15 percent as a discount, or “hurdle” rate – investments must clear a 15 percent “hurdle” before clearing the bar. The 15 percent hurdle incorporates a lot of risk, especially in today’s environment of relatively low interest rate and inflation. Conservative value investors usually use discount rates in the 10 to 15 percent range.

As you build and run models, you’ll see firsthand how the discount rate affects the resulting intrinsic value. Here are a few points to remember:

• The higher the discount rate, the lower the intrinsic value – and vice versa.
• The second-stage discount rate should always be higher than the first stage. Risk increases the farther out you go.
• If you choose an aggressive growth rate, it makes sense also to choose a higher discount rate. Risk of failure is higher with high growth rates.
• If the discount rate exceeds the growth rate, intrinsic value will be low and implode more quickly the larger the gap. Aggressive growth assumptions with low discount rates yield very high intrinsic values.

If you’re worried about earnings and earnings growth consistency and want to factor it in somehow, but don’t want to do a deep statistical analysis on a zillion numbers, Value Line does one for you. At the bottom right corner of the Value Line Investment Survey sheet is a figure called “Earnings Predictability” if the Survey covers the company you’re evaluating.

It’s really a statistical predictability score normalised to 100 (100 is best, 0 is worst). A score of 80 and higher indicates relative safety; below 80 means that you may want to attenuate growth rates or bump up the discount rate to account for uncertainty.

Here again is the set of growth and discount assumptions used for an example. Consistency is important, but growth rates will vary for each company, and discount rates may change also with differing risk assessments.
First-stage growth 10%
Second-stage growth 5%
First-stage discount rate 12%
Second-stage discount rate 15%

Ref: Intrinsic Value Model

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.