Shareholder Returns Explained: Beyond EPS

In the dynamic world of investing, Earnings Per Share (EPS) has long been a cornerstone metric.

However, savvy investors are discovering that relying solely on EPS can lead to misguided decisions.

This article explores the limitations of EPS and unveils superior alternatives that truly capture shareholder value.

By understanding these tools, you can make more informed and profitable investment choices.

The Flawed Beacon: Limitations of EPS

EPS focuses narrowly on per-share earnings, ignoring critical aspects of financial health.

It fails to account for the cost of capital, which is essential for assessing true profitability.

Share buybacks can artificially inflate EPS without creating real value for shareholders.

This distortion makes EPS a misleading indicator in many corporate scenarios.

Earnings management practices further undermine its reliability, as companies often manipulate figures.

Investors tend to undervalue small or zero EPS surprises due to potential manipulation risks.

In high-accruals firms, earnings persistence is low, rendering EPS less predictive of future performance.

Key limitations include:

• Ignoring cost of capital and capital efficiency, which are vital for long-term value.
• Vulnerability to share buyback distortions that mask underlying business health.
• Susceptibility to earnings management, leading to low-quality earnings reports.
• Poor performance in growth stocks and firms with high institutional ownership.

These flaws highlight why a broader perspective is necessary for accurate assessment.

Unveiling "Other Surprises"

Beyond EPS, metrics like revenue surprises offer clearer insights into company performance.

These "other surprises" include revenue, cash flow from operations, and GAAP EPS.

They provide better signals into performance drivers and earnings quality, especially for growth-oriented firms.

For growth stocks, revenue surprises are particularly impactful and often more reliable.

High institutional ownership firms also emphasize these metrics for deeper monitoring.

Types of other surprises:

• Top-line metrics: Revenue, gross margin, and operating profit for persistent insights.
• Cash flow measures: Cash flow from operations per share, indicating liquidity and health.
• Aggregate metrics: Net income, EBITDA, and GAAP earnings, which avoid per-share distortions.

Investors weight these surprises more heavily, with price reactions up to 10 times higher in some years.

This shift underscores the growing preference for less noisy signals in financial analysis.

Economic Profit: The True Measure of Value Creation

Economic Profit (EP) calculates profit after deducting the cost of capital, offering a holistic view.

It rises only when a company creates genuine value above its capital costs, ensuring alignment with shareholder interests.

EP correlates strongly with Total Returns to Shareholders (TRS), outperforming EPS in predictive power.

When ROIC exceeds WACC, EP is positive, indicating sustainable value creation.

Revenue growth combined with EP drives long-term returns, making it a robust metric.

Advantages of EP:

• Incorporates cost of capital for a comprehensive assessment of profitability.
• Less susceptible to accounting manipulations, providing a clearer financial picture.
• Aligns with long-term shareholder value, encouraging strategic decision-making.
• Better predictor of stock performance than traditional metrics like EPS or P/E ratios.

Embracing EP can transform how you evaluate investment opportunities for lasting success.

Total Shareholder Return: A Holistic View

Total Shareholder Return (TSR) combines stock price appreciation and dividends for a complete performance measure.

It offers a comprehensive view of investment outcomes, helping investors gauge true returns.

Decomposing TSR reveals key drivers: EPS growth, multiple expansion, and dividends.

Historically, EPS growth contributes 44%, multiple expansion 42%, and dividends 14% to overall returns.

This decomposition helps investors understand the sources of returns and plan accordingly.

Components of TSR:

• Stock price appreciation from earnings growth and market sentiment shifts.
• Dividends and reinvestments providing steady income and compounding effects.
• Relative TSR benchmarks for performance evaluation against industry peers.

Understanding TSR empowers you to focus on total returns rather than isolated metrics.

Context Matters: Tailoring Metrics to Investment Styles

The relevance of financial metrics varies with investment contexts and company characteristics.

For growth stocks, top-line surprises are crucial and often more indicative of future potential.

Value stocks may still find EPS useful, but should complement it with other measures for accuracy.

Firms with high accruals should focus on revenue and cash flow to avoid misleading earnings.

Institutional investors, especially blockholders, monitor non-EPS metrics closely for effective oversight.

Factors to consider when selecting metrics:

• Growth vs. value stock characteristics, which influence metric effectiveness.
• Level of institutional ownership and monitoring, impacting corporate governance.
• Presence of share buybacks and their distorting effects on per-share figures.
• Earnings quality and persistence indicators, such as accrual levels.

By tailoring your approach, you can enhance investment decisions and risk management.

Designing Better Incentives for Long-Term Value

Over-reliance on EPS or TSR in executive compensation can encourage short-termism and harm sustainability.

Hybrid models incorporating EP or ROIC align incentives with long-term value creation, fostering strategic growth.

This approach encourages decisions that benefit shareholders over extended periods, not just quarterly results.

Recommendations for better incentive design:

• Use metrics that account for cost of capital, such as EP or Economic Value Added (EVA).
• Balance short-term and long-term performance measures to avoid myopic behaviors.
• Incorporate relative TSR benchmarks to mitigate market volatility and ensure fair evaluation.
• Emphasize revenue growth and capital efficiency for enduring success and resilience.

Adopting these practices can drive sustainable corporate performance and investor confidence.

By looking beyond EPS, you unlock deeper insights into shareholder returns and value creation.

Embracing metrics like Economic Profit and Total Shareholder Return leads to more informed and profitable decisions.

This journey towards clarity empowers you to build a resilient portfolio that thrives in any market condition.

Start integrating these tools today to transform your investment strategy and achieve lasting financial success.