At Empire Investing we’re always amused – and a little exasperated – at the use of erroneous financial measures to provide indications of a company’s value or highlight the benefit of an M&A. Earnings per share (EPS) and dividend yield are probably the most commonly used, however when promoted as single metrics (i.e. in isolation) they tell us nothing about value. My business partner The Prince has already highlighted the problems with dividend hugging in an excellent article on Cochlear and Telstra.
I am going to examine the problems with EPS and why an investor should be wary when it is used to justify share prices, raise capital or promote M&A activity.
Increasing and Accretive
When used to justify an increasing share price, a stock value or the benefit of a merger, EPS is often referred to as increasing or “accretive”. Increasing EPS just means the company is pumping out more earnings per share than at some point in the past. If the deal or capital raising is going to increase the earnings per share of the company then investors must be better off surely?
Unfortunately, things are not so simple and the investor needs to examine what’s producing the earnings.
Capital Raisings
Most companies trade at multiples of their underlying equity per share figures. Usually during a capital raising, the entitlement or subscription offer is done at a discount to the share price, which (most likely) will be much greater than the equity per share value. This has the effect of increasing the equity per share base.
For example, say I owned Company XYZ with equity per share of $10.00 and it traded at $30.00 per share. I announce a capital raising, by doubling the number of shares, but I’ll be nice and issue them at $20.00 per share. I’ll tell the market it’s a great deal because I’ll use the capital to increase EPS by 20%. The financial analysts will probably say “Wow – EPS increase of 20%! We’ll upgrade to accumulate” and my current shareholders will get a warm fuzzy feeling in their capitalist glands as they see expansion, bigger dividends and higher earnings ahead for their stocks.
However, when you do the math the equity per share base is now $15.00 per share. So to increase EPS by 20%, I have increased my equity levels by 50%. Before, I was providing my shareholders with an excellent return on their original capital, now I need 50% more capital to increase my earnings by 20%. This is a substantial reduction in my capacity to earn, thus creating a large opportunity cost for all concerned – except the brokers and holders of executive options that are awarded on EPS growth.
Increasing Debt
Debt can be a useful thing to have, but only when it’s financing productive investment. Any company that raves about increasing EPS whilst also piling on the debt should be avoided. If they needed the debt that badly, then they should be using those earnings to fund their business expansion rather than massaging EPS to please the market (and inflate share price).
There are numerous examples of companies who have both raised capital and debt in the same year, and then trumpeted a higher EPS with a larger dividend. Avoid them at all costs as the stewards are poor capital managers and more likely than not trying to manipulate the share price.
Examples Past and Present
A classic example of EPS figures hoodwinking the market is ABC Learning. For several years this company was a golden-child for the analysts, posting ever-higher EPS and growing in size and revenue. Unfortunately few people took the trouble to look at ever-increasing amount of capital being raised by Mr Groves. In one year ABC raised $1 billion and in the process doubled shareholders equity from $0.8 to $1.8 billion. Yet I can assure you the earnings did not increase by more than double. They increased by a little (give anyone a billion dollars and you’d expect some returns) and consequently the EPS looked great compared to the previous year. However, when examining the earnings against the $1 billion used to generate them, something was obviously amiss – and the share price eventually reflected it.
More recently, the prospectus for the merger between WAN and Seven Media Group said the deal would increase EPS by 6.8%. However it failed to mention that WAN’s equity per share would increase by over 400%. Now, an argument can be made that WAN did not show the true valuable of intangible assets on its books, and hence it’s equity per share was artificially low. However, when your equity per share base goes up by 400%, whilst earnings per share increase by 6.8%, something is amiss – even after you adjust for the lack of WAN intangibles.
So, whenever you see “Increasing EPS!” as a justification for a share price of future business deal, be very wary. Look at the capital management behind that number.
Only then will you know the full story.
Disclosure: The author is a Director of a private investment company (Empire Investing Pty Ltd), which has no interest in any business mentioned in this article. The article is not to be taken as investment advice. Readers should seek advice from someone who claims to be qualified before considering allocating capital in any investment.