Review: The bias of one indicator

Share Price

The established perception among investors is that the price of shares and thus, in the long term, their values are driven by the development of company fundamentals whose final outcome is an improving ability to generate free cash flow or, in other words, capital return. According to Graham and Dodd (1940), the fundamental value of a share generally means the value that is justified by facts such as company assets, performance, dividends or clear future outlook. In the long run, share prices ultimately follow the companies' ability to generate cash flow relative to the company's invested capital.

For the company to be able to generate cash flow to shareholders through its business it must invest in capacity to produce products and services intended for sale. This can include purchasing inventories, building a new factory, hiring new employees, or investing in R&D projects. The company expects to generate revenue for each invested euro.

Value creation

The company only generates value through its business and only if the return on invested capital (ROIC) is higher than the cost of capital (WACC). If this is not the case, the business will destroy value in the long run. The same also applies to growth. Growth in itself only generates value if the return on new invested capital (RONIC) exceeds its required return (WACC). History is an indication of the future, but one should always look forward in both business and investing. To simplify and from the viewpoint of future value creation, the investor should focus on how high the return on new invested capital is over time relative to its required cost and, on the other hand, how long the company will be able to maintain a high return on invested capital.

In principle, the investor should therefore be interested in how and with what capital needs the company generates cash flow. This does not necessarily mean that the company should already generate free cash flow. However, the ideal situation for an investor would be to be able to roughly assess when the company starts generating free cash flow and how much and for how long it can produce cash flow. In practice, this exercise is very difficult, but not impossible. Analysts do their best at this job and thus help investors assess the company's future cash flows.

Earnings per share

The established perception in financial theory is that the value of a share is the present value of its future free cash flows. However, in the short term, the market often follows the earnings per share (EPS) figure found in the income statement. Earnings per share is calculated as follows: net result/average number of outstanding shares. Thus, earnings per share can be influenced either by increasing net income or by changing the number of outstanding shares. Of course, generating and improving net earnings depends on the company's capital return (and amount of leverage), but the number of shares can be influenced by, for example, repurchasing and canceling shares. The earnings per share will then improve as the net profit is divided between a smaller number of shares. However, the repurchase and cancellation of own shares does not fully guarantee creation of shareholder value if the shares are bought above their fair value.

Why is EPS, however, a somewhat better indicator than, for example, the net profit of the income statement? Investors want to see a linearly increasing net profit, but the item in the income statement does not in itself take a position on how much one share represents in this net profit. Thus, it is important to examine the net profit based on share-specific figures i.e. through EPS. So seemingly investors want EPS to grow, although this does not necessarily mean that the business will generate value for its owners. Looking at EPS alone can be short-sighted because it does not consider the amount of capital needed to generate net profit or, ultimately, the most important thing for the owner, free cash flow. On the other hand, net profit is only an accounting technical figure and does not in fact indicate how much free cash flow the company has been able to squeeze out with the assets held by the company, i.e. operating capital. For the shareholder, earnings growth destroys shareholder value if the company proportionally requires more capital to increase free cash flow. A good example of when monitoring EPS alone as an indicator of value creation is misleading is a historical examination of the British grocery retail chain Tesco.

The graph shows how EPS grows almost linearly during the review period, but the company's return on investment falls slightly. In other words, the return on the company's new invested capital is on average declining, resulting in a decline in the return on invested capital over the review period. Thus, even if EPS grows, relatively more capital has been needed to achieve this. Therefore, the growing EPS curve does not give a true picture of the business’ value creation potential and is therefore actually misleading.

In this case, growth has even destroyed value at least towards the end of the review period, as the return on invested capital and return on new invested capital have been declining over time and, at the end of the period, are even below the roughly estimated required return.

In the end, instead of an absolute share-specific earnings figure the investor should be more interested in how much the business itself produces relative to the assets it ties up and how the generated cash flow can be reallocated. As a result, capital return indicators (in particular ROIC and RONIC) better reflect the company's operational performance, value creation and management's ability to allocate capital.

Sources:

Graham, B. & Dodd, D. (1940). Security analysis: Principles and technique. (2nd edition). New York: McGraw-Hill.

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