The era of investors’ slavish devotion to EPS is over and it's about time.
According to a report in today's Wall Street Journal, 72% of the 344 companies in the S&P 500 that have reported so far have beaten estimates. Not only that, but earnings growth of 8.1% is the highest it's been in more than two years. Despite this apparently bullish set-up stocks haven't responded, with the overall market still negative by multiple percent even with a three-day winning streak.
It's not just a few blow-ups dragging down the market. According to FactSet just over half of companies "beating expectations" have seen stock gains the next day compared to 58% over the last five years.
So what gives? The Journal has all sorts of thoughts about R&D being rewarded and other earnings quality metrics being favored. I think it's simpler than that. I think for a number of reasons the whole idea of EPS as a performance metric has always been flawed and finally at long last Investors have figured out the scam. Yes, scam.
For decades companies have been driving EPS through buybacks and undercounting dilution from outstanding options and other laughable garbage like so-called "non-GAAP" earnings. It's lunacy.
U.S. companies announced nearly $500b in buybacks last year, the highest total since 2008. This massive expenditure was billed as returning money to shareholders but that’s a triumph of marketing, not management.
Only two of the ten companies that "returned the most cash" to shareholders via buyback dollar amount for the 12 months ending in mid December of last year had outperformed the S&P 500 over the same period. Two. Including dividends an equal weighted basked of these ten stocks had a total return of 13.1% compared to a 28.6% total return for the S&P 500 over the same period.
The lie at the root of EPS
The hard truth is that EPS as an entire concept is based on the false premise of stocks having a terminal value. According to Graham and Dodd’s Security Analysis, the unofficial Bible of valuing stocks, each share of a company entitles the owner to a percentage of the underlying asset. That’s fine as long as there’s a terminal event but is otherwise useless for valuation purposes.
Said in English, unless a company is going to be either sold or liquidated, your proportional share means almost nothing. Exxon (XOM) has a market cap of $390 billion. It’s not going to be purchased or dissolved. Bonds have a terminal value. Equities don’t.
Graham and Dodd wrote in 1934. Their work is a useful primer for students of investing but otherwise all but useless for modern application.
Investors need only be concerned with net income, on-going investments and future earnings potential. The only real way to return money to shareholders is through dividends. Almost everything else is just noise.
The bottom line is the investing public is to be lauded for seeing through the lie of companies creating value by “beating estimates by a penny." In the era of GAAP vs. Non-GAAP, buybacks reducing share count and other accounting shenanigans, reported EPS is all but meaningless.
Earnings are net income. Nothing more. Returning cash to shareholders means sending out dividends. The days of EPS mattering are coming to a close. The result is better markets that are more closely linked to aligning the interests of management and shareholders.