EPS needs a health warning

There has been increased interest in recent years in shareholder value and the various methods of its calculation. The earnings per share (EPS) figure has long dominated top management’s, analysts’ and media commentators’ thinking, but attitudes to EPS now need to be re-examined with a critical eye.

In normal times, if the EPS figure increases substantially every year, it generally takes the share price along with it and keeps boards and investors happy.

But these are not normal times. In a contraction like the one we’re experiencing now, criteria other than EPS need to take precedence, in particular, the cash flow, net cash position and debt load generated in better days when it became fashionable to replace equity with debt because it makes the balance sheet ‘more efficient’.

Massaging the figures
One problem is that EPS figures can be relatively easily manipulated – for example, by buying back your own company’s shares. This is perfectly legitimate if the company concerned has surplus cash. However, some companies execute share buybacks by increasing borrowings, a dangerous thing to do in turbulent times – a lesson the current credit crunch is bringing home.

Another method of manipulating EPS is if you can use your company’s more highly-rated shares to acquire another company on a lower price-earnings ratio. This method was popular among conglomerates in the past and, if the company purchased is large enough, the result can be a substantially increased EPS – even if the earnings of both companies remain exactly the same. It seems like an easily spotted confidence trick, but these shenanigans fooled many investors when it first became de rigeur in the 1960s, right through into the 1980s.

Reported earnings are a very poor indicator of corporate value and incentivising managers using EPS is a bad move – a belief shared by Warren Buffett who says such a practice encourages disingenuous or even dishonest behaviour. As he highlighted in his 2006 letter to shareholders, “The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed – without undue leverage, or accounting gimmickry – and not the achievement of consistent gains in earnings per share.”

Major reasons why EPS fail to reliably measure the economic value of firms include:
• Alternative accounting principles: changes required by accounting standards or, where there is room for manoeuvre, voluntarily adopted, can change EPS, but don’t affect economic value;
• Risk is excluded. Both business risk and financial risk are not accounted for in annual reports;
• Investment requirements are excluded. Changes in, for example, working capital are not considered in reported earnings;
• Dividend policy is not considered;
• The time value of money is ignored. Present value calculations are not part of reported earnings; and
• The greater role that intangible assets play in our economic system, which has moved from an industrial economy towards a services and knowledge-orientated economy.

Despite this, EPS is still often the focal point of annual reports. FDs should remember that over-concentration on EPS – especially when it leads to a decrease in the cash position because the firm has increased its debt load to engage in a share buyback – can cause liquidity problems.

The use of other ratios should be encouraged, instead. After all, many companies logically make a loss in times of recession and this renders EPS and the P/E ratio useless. However, ratios that use cash flow can still be valid: when a company is making losses, investors, banks and credit agencies start to focus on the net cash position – and it is still possible for a company to have a positive cash flow when making losses.

‘Free cash flow’ is the basis for a number of investment decisions. A further step is to divide free cash flow into market capitalisation to arrive at a price/cash flow multiple. This will normally be less than the P/E ratio and is often in single figures.

Analysts find EBITDA, earnings before interest, taxes, depreciation and amortisation, a useful measure as it attempts to look at the cash flow available to service all the obligations of a company – debt as well as equity – and allows a comparison of companies with different capital structures or accounting treatments.

EBITDA should properly be compared with enterprise value (EV): most investors want to see an EV/EBITDA ratio of no more than 10 times. The ratio is useful for transnational comparisons because it ignores the distorting effects of individual countries’ tax regimes. It is also valuable in spotting possible takeover candidates, which would have low EV/EBITDA ratios.

Suppliers and customers
Over the next few months, finance directors should examine not only the financials of their business, but also those of its suppliers, customers and competitors.

EPS can still be a useful ratio here, but needs to be used in conjunction with other ratios and, particularly in the present business climate, those related to cash flow. Interest payments on debts are tax deductible, unlike dividends, and those payments must still be made whatever the weather. Conversely, when the cash position is tight, a company has the flexibility to reduce dividends, or not pay them at all until the position improves. Remember, businesses go bust not because of lack of earnings, but lack of cash.

Useful links
To see Warren Buffett’s comments on EPS in the 2006 letter to shareholders, go to www.berkshirehathaway.com/letters/letters.html

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