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A common buzz for investors is learning that their holdings have increased earnings per share. EPS growth is thrown around Wall Street circles, analyst discussions, corporate conference calls and investment talk shows as if it is the central focus for companies. What professional investors know and many misrepresent, is that earnings are important but not a complete driver for the true cash flows a company is generating.

Most investors agree that the value of a firm is the present value of its future cash flows. For the typical industrial firm, EPS only represents approximatley 50% of cash flow. If you believe that the value of a firm is the sum of its future cash flows, using EPS alone to value a firm can cause you to miss 50% of the cash flows.

The analysis we use at ValueExpectations.com has a broader focus that emcompasses all cash flows and moves beyond EPS. While capturing the true cash flow the entire firm is generating and addressing their cost of capital making several other adjustments along the way, it provides a more economic outlook for a company. We call this analysis Economic Margin:

It is not uncommon for companies to grow EPS while having declining EM’s. This occurs when the cost for the investment required to yield the increasing EPS is more than the cash flow generated from the investment.

Unlike traditional measures, EMs consider the “profitability” of EPS growth, eliminate accounting distortions, and are comparable across time and industry. By analyzing a company’s EMs through time, investors gain a more accurate account of levels and changes in a company’s current profitability and value.

If earnings are a true proxy for performance, there should be a correlation between a company growing earnings and its price to earnings ratio. As a surprise to many investors, there is actually little to no correlation between earnings growth and price to earnings ratios (left chart below).

Because of changes in depreciation, inventory methodologies, write-offs, asset mix, growth and inflation, accounting data changes for non-economic reasons. Therefore, accounting data can give the wrong buy/hold/sell indication. This is illustrated by the poor link between traditional accounting measures and stock prices (left chart below). Economic Margins (EMs) are systematically calculated for over 8,000 U.S companies. The resulting values have a much stronger link to stock prices than traditional accounting data provides (right chart below). As a result, portfolio managers and analysts have a much more accurate starting point for their analysis.

Below are a few examples of companies that have done an exceptional job growing EPS but have fail to improve their economic profitability resulting in underperformance.  Click here to read a related article: AFG Basic Valuation Concepts

 Click here to read a related article: AFG Basic Valuation Concepts

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