What does EPS stand for in finance?
EPS (earnings per share) is an important piece of financial information investors focus on. Management teams are congratulated when they grow EPS. The P/E multiple, a popular valuation metric, is based on EPS. But what is the real significance of EPS? Does earnings per share growth create value?
EPS obsession: Why?
Why are investors and companies’ management so obsessed with EPS? Because earnings per share neatly summarize the earnings generated for shareholders, and the shareholder’s perspective appeals both to investors and to management. Besides, EPS is very easy to calculate and understand: there is hardly anything complex about taking a company’s net income and dividing it by its number of shares. In addition to being relevant to shareholders, management may have a personal reason to focus on EPS, such as when compensation is linked to the company’s EPS performance.
What is in EPS
First things first: Learning that a company has an EPS of $1.00 is not particularly meaningful in itself. How about comparing EPS between companies? Is a company with higher EPS performing better than a company with lower EPS? This comparison has limited value, since it only indicates that an investor holding one share in both companies would “own” a higher net income in the first company than in the second company, but this is not enough to establish whether the first company is a better investment, or is performing better, than the second.
A more interesting exercise is the analysis of EPS growth. Notoriously, management of listed companies goes to great lengths to record EPS growth, and they are profusely congratulated when they achieve it. But does an increase in EPS result in additional value creation for shareholders? The answer is: not necessarily.
Consider the following case. Company ABC issues debt and uses the cash proceeds to repurchase its own shares. Will EPS rise? If it does, should shareholders rejoice? The impact on EPS may be positive or negative, depending on the cost of debt and on how many shares are repurchased. Assume that EPS rises. Shareholders will not necessarily be better off, because leverage has increased, so shareholders are taking more risk. The EPS increase may or may not compensate shareholders for the additional risk. Bottom line: EPS growth in itself is not a conclusive sign of value creation.
How to calculate earnings yield
If an increase in EPS is not necessarily good news, how can shareholders use EPS for their advantage? The earnings yield is a simple and powerful tool to use for this purpose.
Earnings yield (%) = EPS / Share price
The earnings yield shows the earnings “owned” by a shareholder for every dollar invested in the stock at the current stock price. In other words, it is the % return made by an investor. Notice that the earnings yield is the inverse of the P/E multiple, which means that this multiple in reality expresses a rate of return on equity.
The earnings yield can help an investor establish whether a stock is a good investment. In general terms, if the earnings yield for all future years exceeds the cost of equity, the investor has found a value-creative investment opportunity. The flipside is that such opportunities do not come around very often… The following example will clarify this. Imagine a stock that trades at 20x P/E on next year earnings – not an uncommon multiple. The earnings yield is only 5%, which is very unlikely to cover the investment risk taken by a shareholder (even in the current low-interest-rate environment, investment grade corporate bonds can easily yield 5% or more). Does it mean that investors should absolutely avoid stocks trading at such multiples? Not necessarily. Value is created (or destroyed) in the long-term, but our earnings yield analysis only looks at the short-term. For most stocks, the earnings yield falls short of the cost of equity exactly because investors are betting on a benign future, i.e. that earnings will increase. So what about those stocks that trade on an earnings yield higher than the cost of equity? Two scenarios are possible – either the future earnings are expected to decline, or sellers are giving away a free lunch.
This is a good acquisition… Right?
Let us now look at a simple and useful application of the earnings yield. Examine the following scenario:
Company A is considering investing $100m in a project (or a corporate acquisition) that is expected to generate net income of $7m a year. The investment’s earnings yield is therefore 7%. Company A can issue $100m of debt at an interest rate of 4% post-tax. The earnings yield is therefore higher than the cost of finance.
- Will the investment increase EPS?
- Will the investment create value for shareholders?
The answer to the first question is easy: Yes, Company A increases its earnings by $7m and pays a post-tax interest of $4m, therefore their earnings increase and so does EPS (the number of shares is constant).
A useful general rule can be extracted from the case above: if the earnings yield exceeds the cost of capital, the investment will be EPS accretive.
This type of analysis is often applied using P/E multiples: if the investment P/E is lower than the debt P/E (the inverse of the cost of debt), the investment is EPS accretive. This is what is called the “relative P/E analysis” in M&A.
The second question is trickier. It is tempting to compare the earnings yield with the cost of financing and therefore conclude that the investment creates value. However, that comparison is flawed. To create value, the return on equity (the earnings yield) needs to exceed the cost of equity. But what is the cost of equity in the above example? It is not determined, and therefore it should be estimated before any conclusion can be made. Depending on the company’s capital structure and on the type of operating business, the cost of equity may be higher or lower than 7%. Should the cost of equity be higher than 7%, the investment would destroy value for shareholders, even if the investment is EPS-accretive.
The bottom line is that EPS growth in itself does not mean that value is created for shareholders. EPS provides some information about the dollar return made by shareholders, but two more pieces of information are needed in order to assess value creation: the shareholders’ investment (the price at which they buy the shares) and the risk that shareholders bear (the cost of equity).
Please do not hesitate to contact us, if you are having trouble viewing or accessing this article.
Copyright© 2016 AMT Training