By Johannes de Wet
Pundits in the know and other users of financial statements perhaps not that well informed have been touting earnings per share (EPS) as the holy grail of financial performance for a very long time. The requirement for companies in the United States to report earnings every three months has aptly been labelled ‘quarteritis’ and brought immense pressure to bear on managers to deliver acceptable EPS performance. Managers internationally are all too aware of the impact of EPS surprises on share prices and as a consequence a questionable over-emphasis on short-term EPS performance has resulted.
This article outlines the popularity of EPS as a financial performance yardstick, but also addresses three glaring limitations, namely the inability of EPS to reflect shareholder wealth creation, EPS management, and an inherent bias towards positive EPS growth. The focus is then placed on the issue of the inherent bias towards positive EPS growth and a case study approach is used to analyse the EPS growth of Shoprite Holdings. The analysis reveals that inflation, the increased asset investment due to retained income and debt, operating leverage, and financial leverage are major factors that determine EPS growth. Any EPS growth generated over and above the four factors just mentioned is termed ’excess’ EPS growth.
Popularity of EPS
Even today, EPS is considered to be the single most popular, widely used financial performance benchmark of all. Graham et al surveyed 400 financial executives in the US and reported that the majority, by far, were of the opinion that earnings were the most important performance measure they report to outsiders.[i] EPS is also the linchpin undergirding strategic decision-making like share valuations, management performance incentive schemes, and merger and acquisition negotiations. EPS is simple to calculate and easily understood and management is congratulated when there is positive EPS growth. It is no surprise that managers take a special interest in EPS when their compensation is linked to the EPS performance of the company.
Most investors are familiar with the valuation multiple, the P/E ratio, which has EPS as the denominator and the continued relevance of EPS and EPS growth in modern-day share valuation methodology is still widely acknowledged. Adkins et al attribute the obsession with EPS to the fact that EPS neatly summarises the earnings generated for shareholders and the shareholder’s view appeals to investors and management alike.[ii] Brown comments that when companies, under severe pressure to meet market expectations, underperform EPS estimates by only a few cents, experience ‘double-digit nosedives’ in share prices.[iii] Big share price movements in response to earnings surprises reinforce the perception that short-term earnings rather than long-term cash flow expectations drive share price changes.
Failure of EPS to reflect shareholder value creation
According to Jensen the objective of increasing the long-term market value of the firm has its roots in 200 years of research in economics and finance.[iv] Value is determined by the magnitude, timing and risk of the future free cash flows of the company. Equity valuation methods use discounted cash flow techniques to estimate the present value of future cash flows in order to determine the value of the shares today. Companies practically pursue the goal of value maximisation by investing in projects with returns above the cost of capital, thereby yielding positive net present values (NPVs).
Stewart asserts that companies that manage EPS are “asking for trouble” and commented that one of the significant contributors to the demise of Enron was that the management was, in their own words, “laser-focused on EPS”.[v] Mauboussin defines the fundamental problem with EPS as the fact that a company can take decisions that increase EPS but destroy shareholder value.[vi]
EPS does not take into account the cost of equity and as a result, does not reflect the full cost of running a business. Companies with heavy debt burdens reflected in high levels of financial gearing have a high cost of equity due to the increased risk. Penman indicates that companies can increase EPS simply by increasing their borrowing; however, more borrowing does not necessarily create more value.[vii] Rappaport reports that the widespread obsession with short-term performance is the ‘root cause’ of recent corporate scandals and that there is no greater enemy of stock market allocation efficiency than the fixation on earnings.[viii] In conclusion, Rappaport directed that companies should make strategic decisions that maximise expected future value, even at the expense of lower near-term earnings.[ix]
Management can and does resort to accounting footwork to maximise EPS rather than shareholder value. This is substantiated by Brown who states that there is an unprecedented systemic reporting problem and the manipulation of earnings to the point of including bogus earnings, are on the rise.[x] Stewart, in referring to Enron, remarks: “the company’s top brass became so caught up in the vicious EPS management cycle that they resorted to deceitful accounting chicanery to hide much of the debt they were using to finance their EPS growth”.[xi]
Bergstresser and Philippon found that there is a higher incidence of the use of accruals to manipulate earnings at companies where the CEO’s potential compensation is more closely linked to the value of the shares.[xii] They cited the capitalisation of operating expenses by WorldCom as a telling example of the erroneous application of accrual accounting. Myers et al investigated the quarterly earnings strings of at least twenty quarters for companies in the US.[xiii] They find significant evidence of earnings management where long periods of unbroken positive EPS growth cannot be ascribed to underlying economic fundamentals or chance.
Inherent bias towards positive EPS growth
The sustainable growth rate (SGR) of a company is dependent upon not only its return on assets, but also on its financial policies.[xiv] The original SGR formula is defined as follows:
SGR = D/E(R – i)p + Rp
D = Debt
E = Equity
R = Percentage return on assets after tax
i = Percentage interest rate on debt after tax
p = Proportion of earnings retained
Implicit in the SGR formula are the assumptions that the profitability of the assets, the capital structure and the asset turnover, the dividend policy, as well as the average interest rate on debt and the tax rate all remain constant.
If it is assumed that a company retains some profits after paying a dividend in a given year, it can be argued that in order to maintain the capital structure, an appropriate amount of additional debt can be raised. The retained profit plus the additional debt theoretically constitute the total amount of additional capital the company has at its disposal for investment in assets for the next financial year. Assuming a constant asset turnover (no spare capacity), the volume of sales should increase by the same percentage as the assets in the next year.
Furthermore, the impact of leverage, both operational and financial, and inflation should cause an even more dramatic percentage increase in earnings compared to the increase in sales volume. The higher amount of earnings generated from a larger asset base in the next year, divided by the same number of issued ordinary shares would most likely lead to a higher EPS, even if the company actually has weaker profitability performance relative to sales and assets than in the previous year. This phenomenon represents an inherent bias towards positive EPS growth when there are positive retained earnings in the preceding year.
Data and EPS growth analysis model
The data for the case study company Shoprite Holdings was extracted from the McGregor BFA database and for reasons of comparability, standardised financial statement information was used. An Excel spreadsheet model was developed and the data that was inserted include the sales, variable costs, fixed costs, profit before interest and tax (PBIT), interest paid, profit before tax (PBT), taxation, profit after tax (PAT), minority interest, preference dividend, earnings, ordinary dividend and retained income.
The model was constructed based on the following assumptions:
- The capital structure remains constant, that is, for increases in retained profits, long-term debt is added proportionately.
- There are no new share issues, buybacks, share splits, scrip dividends or bonus share issues during the year.
- The capital structure is determined by a combination of equity and long-term debt, which finance total net assets.
- Total net assets consist of fixed assets plus financial assets plus net working capital.
- Asset turnover, determined by dividing sales by total net assets, remains constant.
- There is no preference shares issued or the issued amount is insignificantly small.
The model uses the input data to determine the level of operating and financial leverage and analyses the EPS growth percentage by identifying and quantifying the factors that contribute to its value. The use of standardised financial statements may cause the calculation of EPS for the case study company to be different from the reported EPS per actual published statements. The results of the model applied to Shoprite Holdings are given in table 1.
Table 1 Results for Shoprite Holdings
|2012 Actual||2012 Projected before inflation||Note||2012 Projected after inflation||Note||2011 Actual||2011 Percentage|
|Sales||82 731||89 799||1||94 827||2||72 298|
|Variable cost||77 011||83 654||3||88 338||4||67 351|
|Contribution||5 720||6 145||6 489||4 947|
|Fixed cost (estimate)||886||886||936||5||886|
|PBIT||4 834||5 259||5 553||4 061|
|PBT||4 611||5 102||5 396||3 935|
|Tax||1 528||1 757||7||1 858||8||1 355||34,4% of PBT|
|PAT||3 083||3 345||3 538||2 580|
|Minority interest||16||26||9||27||10||20||0,8% of PAT|
|Earnings||3 067||3 319||3 511||2 560|
|Ordinary dividend||1 598||1 279|
|Retained income||1 469||1 281|
|Number ordinary shares (m)||504,33||504,33||504,33||504,33|
|EPS actual vs benchmark (growth)||19,8%||17,34%|
|LT debt||1 082||17,0%|
|Total net assets||6 374|
|Adjusted net asset turnover (sales/total net assets)||11,343|
|CPI inflation rate||5,6%|
|Operating leverage (contribution/PBIT)||1,22|
|Financial leverage (PBIT/PBT)||1,03|
|Total leverage (contribution/PBT)||1,26|
|Percentage volume change in sales (before inflation)||24,21%|
|Projected change in earnings (volume change x total leverage)||30,43%|
|Projected increase in earnings excluding increase in interest (previous year earnings x % change)||779,05|
|Subtract increase in interest after tax and minority interest (incr int x (1-tax rate) x (1-min int))||19,84|
|Net increase in projected earnings should be||759,21|
|Test: Projected earnings (before inflation) minus 2011 earnings||759,21|
|Retained income||1 281,0|
|Additional capital available||1 542,9|
|x Asset turnover||11,3|
|Additional sales next year||17 500,7|
|2011 Sales||72 298,0|
|Projected 2012 sales before inflation||89 798,7|
|Note 2||x (1+inflation rate)||Analysis of EPS growth %||19,80%|
|Note 3||Proj sales x var cost % prev yr||Inflation||7,48%|
|Note 4||Proj var cost x (1 + infl)||Higher capital, assets & sales||24,21%|
|Note 5||Fixed cost x (1 + infl)||Operating leverage||5,28%|
|Note 6||Int + int on additional debt||Financial leverage||0,94%|
|Note 7||Proj PBT x tax rate||Additional interest after tax and min int||0,78%|
|Note 8||Proj PBT after infl x tax rate||‘Excess’ growth||17,34%|
|Note 9||Proj PAT x min int %||19,80%|
|Note 10||Proj PAT after infl x min int%|
In table 1 it is shown how the actual EPS of Shoprite, based on standardised data, for 2011 is determined at 507,60 cents and at 608,13 cents for 2012. The actual growth in EPS is recorded as 19,8%. However, given the retained income of R1,281 million in 2011, and considering the assumption of a constant capital structure, an additional R261,9 million can be borrowed (Note 1).
The total additional capital of R1 542,9 million multiplied by the adjusted asset turnover of 11,343, yields an amount of R17 500,7 million in additional sales projected for 2012. Based on this projection of increased sales volume, a projected EPS of 658,14 cents is calculated. After adjustments are made for inflation, the projected EPS for 2012 is determined as 696,12 cents. When the actual EPS for 2012 of 608,13 cents is compared to the projected 696.12 cents and the difference is divided by the 2011 EPS of 507,60 cents, it indicates that the company actually underperformed the projected EPS by 17,34% (of the 2011 EPS).
A more complete analysis of the original 19,8% EPS growth in 2012 is given in the bottom right of the table. The analysis indicates that 7,48% of the actual EPS growth can be attributed to inflation. The retained income of 2011, combined with the additional long term debt, should have enabled the company to generate more sales and earnings in 2012, contributing to an increase of 24,21% in EPS, without taking into account the impact of leverage.
It is estimated that operating leverage should cause EPS growth to increase by 5,28% and that financial leverage contributes only 0,94% to the EPS growth. The additional interest on the increased long-term loans has an insignificant impact of -0,78% on EPS growth and the remaining -17,34% represents the ‘excess’ EPS growth the company was (not) able to generate over and above the additional capital invested, inflation and the impact of leverage.
Few would contest the supremacy of EPS as the single most well known, yet also most controversial, financial performance measure available. In spite of being the perennial favourite among financial experts and laymen alike, EPS is predisposed to gross misrepresentation and erroneous interpretation. Three pertinent issues that contribute to the unreliability of EPS were addressed, namely the failure of EPS to reflect shareholder value creation, earnings management, and an inherent bias towards positive EPS growth.
Superficial analysis and interpretation of EPS growth without recognising the inherent bias towards positive EPS growth and the identification of contributing factors that make up the EPS growth percentage would not conducive to sound decision-making.
[i] J R Graham, R H Campbell and S Rajgopal, The economic implications of corporate financial reporting, Journal of Accounting and Economics, 40(1–3) (2005):3–73.
[ii] Adkins Matchett and Toy, EPS – the holy grail or red herring of M&A analysis, Technical update, February 2010, http://www.amttraining.com/amt-online/technical-updates/eps-the-holy-grail-or-red-herring-of-ma-analysis/ (accessed 8 January 2014).
[iii] P R Brown, Earnings management: a subtle (and troublesome) twist to earnings quality, Journal of Financial Statement Analysis, 4 (1999):61–63.
[iv] M C Jensen, Value maximization, stakeholder theory and the corporate objective function, Business Ethics Quarterly, 12(2) (2002):235–256.
[v] G B Stewart, Enron signals end of the earnings management game, EVAluation, 4(5) (2002):1–6, http://www.sternstewart.com.br/publicacoes/pdfs/enron_signs_the_end_of_the_earnings_management_game.pdf (accessed 8 January 2014).
[vi] M Mauboussin, In defense of shareholder value: setting the record straight on what shareholder value really means, Legg Mason Capital Management: Mauboussin on Strategy, 5 June 2009, http://www.leggmason.fr/pdf/mauboussin_articles/ShareholderValue.pdf (accessed 8 January 2014).
[vii] S H Penman, Discussion of ‘on accounting-based valuation formulae’ and ‘expected EPS and EPS growth as determinants of value’, Review of Accounting Studies, 10(2) (2005):367–378.
[viii] A Rappaport, The economics of short-term performance obsession, Financial Analysts Journal, 61(3) (2005):65–79, http://cmsu2.ucmo.edu/public/classes/young/Guidance%20Research/The%20Economics%20of%20Short-Term%20Performance%20Obsession.pdf (accessed 8 January 2014).
[ix] A Rappaport, Ten ways to create shareholder value. Harvard Business Review, 84(9) (2006):66–76.
[x] Brown, ibid.
[xi] Stewart, ibid.
[xii] D Bergstresser and T Philippon, CEO incentives and earnings management, Journal of Financial Economics, 80 (2006):511–529.
[xiii] J N Myers, L A Myers and D J Skinner, Earnings momentum and earnings management, Journal of Accounting, Auditing & Finance, 22 (2006):249–284.
[xiv] A J Zakon, Growth and financial strategies, Boston Consulting Group, Boston, Massachusetts, 1971.
Johannes de Wet is a professor in the Department of Financial Management, University of Pretoria
This article was originally published in the February 2014 issue of Accountancy SA.