Boost earnings without improving returns

All the measures of a company’s performance, its earnings per share (EPS) may be the most visible. It’s quite literally the “bottom line” on a company’s income statement. It’s the number that business journalists focus on more often than any other, and it’s usually the first or second item in any company press release about quarterly or annual performance. It’s also often a key factor in executive compensation.

But for all the attention EPS receives, it is highly overrated as a barometer of value creation. In fact, over the past ten years, 36 percent of large companies with higher-than-average EPS under-performed on average total return to shareholders (TRS). And while it’s true that EPS growth and shareholder returns are strongly correlated, executives and naïve investors sometimes take that relationship too seriously. If improving EPS is good, they assume, then companies should increase it by any means possible.

The fallacy is believing that anything that improves EPS will have the same effect on value creation and TRS. On the contrary, the factors that most influence EPS—revenue growth, margin improvement, and share repurchases—actually affect value creation differently. Revenue growth, for example, can increase TRS as long as the organic investments or acquisitions behind it earn more than their cost of capital. Margin improvements, by cutting costs, for instance, can increase TRS as long as they don’t impede future growth by cutting essential investments in research and development or marketing.

For example, to improve EPS, managers at one company committed to an aggressive share-buyback program after several years of disappointing growth in net income. Five years later, managers had retired about a fifth of the company’s outstanding shares, increasing its EPS by more than 8 percent. Yet the company was merely retiring shares faster than net income was falling. Investors could see that the company’s underlying performance hadn’t changed, and the company’s share price dropped by 40 percent relative to the market index.

Share repurchases seldom have any lasting effect on TRS—and that often comes as a surprise to managers and investors alike. Given how often we hear executives advocate share repurchases because of their effect on EPS—and make the occasional argument for taking on debt to execute them—it is worth exploring the relationship between buybacks, EPS, and shareholder returns. We’ll begin by examining the empirical evidence and then look at the logic behind so many decisions to repurchase shares.