This is part two of a two part series, see part one here.
Focus on return on capital and its relationship with EPS
Earnings per share (EPS) has a tenuous link with total shareholder returns (TSR), according to Michael J. Mauboussin and Dan Callahan, CFA from Credit Suisse. They note that earnings management is widespread and commonplace according to numerous surveys in the topic. Earnings management is defined as management sacrificing long term goals such as additional investments to meet a quarterly earning target set by analysts’ consensus. Despite this, investors and executives focus on EPS and its growth rate, assuming that EPS and firm value creation are closely linked.
Instead, Mauboussin and Callahan suggest that investors focus on returns on capital invested and their relationship with EPS growth. High EPS growth in isolation does not fully reflect value created as it does not consider capital intensity and the cost of capital used. Investors should know the cost of capital of firms considered for investment first, and then compare such cost to EPS growth. For example, if a firm’s EPS growth is exactly the same as its cost of capital, earnings growth is value neutral. Likewise, if a company’s EPS is growing faster than its cost of capital, EPS growth increases value.
Mauboussin and Callahan also studied the relationship between cash flow return on investment (CFROI®) and EPS. They note that increases in CFROI® will always increase value for any level of EPS growth, all else remaining equal.
Mean reversion is expected by markets
Mauboussin and Callahan also studied the relationship between TSR and CFROI®. If investors selected firms in 2002 that will be in the quintile that generated the highest CFROI® ten years later (Q1), they would have enjoyed returns of about 20% with low variability. The chart below shows that for lower CFROI® quintiles, returns steadily decrease suggesting a reversion to the mean. In Credit Suisse’s view, this suggests that the expected value of firms’ CFROI® is close to the mean. Hence, the market rewards firms with higher CFROI® than the mean with excess returns and punishes firms with returns that fall below the mean (companies in Q5).
Mean reversion can also be driven by non-quantitative factors, such as luck and competitive forces. If an industry is generating high return on capital and EPS growth, it will attract more competition and investment. Within this industry, some firms that improve CFROI® will likely generate excess returns while some other firms negatively affected by the competition may change places from Q1 to Q3 or Q4. The latter will likely see their excess returns decrease relative to industry’s mean.