EPS Games
A super-common metric to evaluate a company's performance is to use its "earnings per share" (EPS). Let's look at this with an example. Company A generates $100 of earnings and has 100 shares outstanding. Its EPS is $100/100 = $1. A year passes, the company now generates $110 of earnings - its EPS is now 110/100 = $1.1 for a 10% increase (over the previous year). When used correctly, EPS allows an investor to quickly compare earnings across time (or, even across companies) to determine quality of earnings.
Now let's meet Company B. They also have $100 in earnings and 100 shares outstanding. Their EPS initially is also $1.0. But they are out of ideas for the coming year. So they get financially creative. See the cool thing about EPS is that it has a denominator. Instead of increasing the numerator (E) which requires hard work, they can decrease the denominator (S). So when next year the earnings are flat at $100, the company buys back 10 shares so the outstanding shares are now 90. Now EPS is 100/90 = 1.11 for approx. 10% increase - same as company A.
But company A had to sweat for its earnings. Company B simply financially engineered its earnings.
This is common in Wall Street even among so-called blue chip companies. Yes, remember Big Blue (or, IBM). Their financial Aladdin (Lou Gerstner, former CEO) repeatedly rubbed the stock buy-back lamp to juice its earnings. His target as CEO was $20 EPS. Wall Street ate it up: lots of favorable reports, a rising stock price (because IBM had better EPS). Yeah, right.
Other examples abound. This year alone $1.2 trillion (yes, that's trillion with a T) - almost 6% of a $20 trillion US economy - will be spent on share buy-backs. (64 companies that spent the most on buybacks saw an average 22\% decline in market value. These include Sears, J.C. Penney, Hewlett Packard, etc.)
Share buy-backs drive up share prices for two reasons -
- greater demand induced by the company itself, and
- investors buying into the rosy picture being presented by companies even though, for some companies, their financial health may have actually declined.
So the message is that when you look at companies and valuation, don't be swayed by simple EPS stats or a company's "earnings beat." Dig a little deeper to gauge for yourself how well the company is doing. But - a good rule of thumb should be this: if a company is doing buy-backs, it warrants scrutiny. If it is financing buy-backs with debt (next section), it warrants still more scrutiny. (Some very good companies like Facebook, Google, etc. do buy-back stock to fund employee stock grants, etc. but these amounts are relatively small.)
(This is yet another reason to stay away from individual stock investing - too hard for people like us to dig through financial statements, etc. to decipher if any such games are being played. The link above on IBM shows how even financial reporters well-versed in the art of deciphering company financials can find it confusing.)
Funding share buy-backs with debt
Company B has decided to buy back its shares. Where does it get the money?
Well, it can either use its cash to buy back shares or it can issue new debt to fund such purchases. Sadly for us as investors, many companies are increasingly opting for issuing new debt to fund such buy-backs. For marginal companies (like Company B in our example), this is compounding the problem: a stagnating business, greater debt, and the illusion of success powered by rising stock price.
Last year in fact $1.7 trillion was issued as new corporate bonds with a good fraction being used for share buy backs.
So what's the takeaway?
Takeaway #1: Don't buy individual stocks unless you have really done your homework. Low-cost index funds tied to leading indices (such as S&P 500, or Russell 2000, etc.) are a good alternative insulating you from individual company performance (and, shenanigans, if any).
Takeaway #2: Don't assume that just because a stock price is rising that its financial outlook and health are rising too. Verify that this increased stock price is due to rising earnings and not just financial engineering!
Good luck!
Submitted June 17, 2018 at 09:43AM by arnexa https://ift.tt/2JYP7gY
