In business schools, managers are taught to maximize the net present value (NPV) of future cash flows. In the real world, managers consistently ignore this advice. When asked, they repeatedly say they maximize earnings per share (EPS). “Firms view earnings, especially EPS, as the key metric for an external audience, more so than cash flows. (Graham, Harvey, and Rajgopal, 2005)”
Researchers have spent decades trying to convince managers to stop using EPS because there are situations where it produces suboptimal outcomes. Researchers have known this for decades (May, 1968; Pringle, 1973; Stern, 1974).
But, right now, that is different from how the world works. So, if you are trying to explain how real-world managers make decisions, you should model them as something other than NPV maximizers.
We propose a theory of corporate finance based on the idea that firm managers maximize EPS: the difference between net operating profits and interest expense divided by total shares outstanding. In our model, firms engage in actions that increase the numerator (net earnings attributed to shareholders) more than the denominator (the number of shares). This simple logic explains many important empirical patterns, such as firm leverage, share repurchases, cash accumulation, and M&A payment methods. For example, a firm engages in a debt-financed repurchase if the negative impact of the increased interest expense on EPS (through the denominator) is smaller than the positive impact associated with decreasing the number of shares (through the numerator).
We can broadly classify firms’ corporate behaviors into two categories: growth and value firms. To see this distinction, consider the choice of capital structure: whether to use equity financing or a combination of equity and debt. The determining factor will be the capitalization rate of the firm’s assets: the discount rate on the firm’s cash flows minus the cash-flow growth rate. Firms with low capitalization rates have high share prices, making them reluctant to borrow. These so-called “growth” firms can raise a lot of money by issuing a few shares, so they view debt as an expensive financing option. In other words, the interest rate of the cheapest (risk-free) debt would be higher than the earnings yield (earnings-to-price ratio). By contrast, firms with high cap rates strategically choose to lever up. These so-called “value” firms have comparatively low share prices and view debt as the cheaper financing option. For these firms, the interest on the debt can be lower than the earnings yield.
In a world in which managers maximize EPS, corporate policies aim to enhance the earnings attributed to shareholders (measured as EPS). And the set of corporate policies that delivers higher earnings per share of ownership differs for growth and value firms given the difference in perceived cost of the different sources of capital. For example, growth firms will accumulate cash; value firms won’t. Value firms will repurchase shares; growth firms won’t. Growth firms will issue equity to pay for acquisitions; value firms won’t.
The data about corporate policies over the last three decades is consistent with the model’s predictions. In the cross-section of firms, growth firms have a significantly lower leverage ratio, hold more cash, are less likely to engage in repurchases, and use equity as a payment method in mergers and acquisitions. In contrast, value firms have significantly higher leverage, hold a minimum level of cash, are much more likely to engage in repurchases, and are much less likely to use equity as a means of payment in acquisitions.
Compare our model with the current theories in corporate finance. Existing theories in corporate finance are typically designed to explain one or a small set of empirical patterns. A model where the firm manager is an NPV maximizer can only describe the choices researchers would like her to make. If you want to predict how the manager will actually, you need to model her as an EPS.
Overall, our model provides a unifying framework for understanding corporate policies. It uses EPS maximization as a single principle that guides managerial decision-making. Not only is it a parsimonious model, but it is also true to managers’ testimonials about what they do.
REFERENCES
Almeida, H. (2019). Is it time to get rid of earnings-per-share (EPS)? Review of Corporate Finance Studies 8(1), 174–206.
Graham, J., C. Harvey, and S. Rajgopal (2005). The economic implications of corporate financial reporting. Journal of Accounting and Economics 40(1–3), 3–73.
May, M. (1968). The earnings per share trap. Financial Analysts Journal 24(3), 113–117.
Pringle, J. (1973). Price earnings ratios, earnings-per-share, and financial management. Financial Management 2(1), 34–40.
Stern, J. (1974). Earnings per share don’t count. Financial Analysts Journal 30(4), 39–43.
Stern, J., J. Shiely, and I. Ross (2002). The EVA challenge: Implementing value-added change in an organization. John Wiley & Sons.
Stern, J., B. Stewart, and D. Chew (1995). The EVA financial management system. Journal of Applied Corporate Finance 8(2), 32–46.
Welch, I. (2011). Corporate finance. Prentice-Hall.
This post comes to us from professors Itzhak Ben-David at Ohio State University’s Fisher College of Business and Alex Chinco at City University of New York’s Baruch College, Zicklin School of Business. It is based on their recent paper, “Modeling Managers As EPS Maximizers,” available here.