110  The Stock Market Is Smarter Than You Think Myths about Earnings So far, we’ve made the positive case for managers to focus their energy on growth at an attractive ROIC. Yet some companies go to great lengths to achieve a certain earnings per share (EPS) number or to smooth out their earn- ings. This is wasted energy. The evidence shows that these efforts aren’t worth it, and they may actually hurt the company. We’re not saying that EPS doesn’t matter. Companies that create value often have attractive earnings growth, and earnings will equal cash flow over the life span of the company. But not all earnings growth creates value. Con- sider the three most important drivers of EPS growth: revenue growth, margin improvement, and share repurchases. As we’ve pointed out, revenue growth (especially organic growth) is a powerful driver of value if it generates a return on invested capital exceeding the cost of capital. Margin improvements that are coming purely from cost cutting are not sustainable in the long term and might even hurt a company’s future growth and value creation if investments in research or marketing are cut back. Share repurchases typically increase EPS but also increase a company’s debt or reduce its cash. In either case, this leads to a decline in a company’s P/E, which affects the increase in EPS so that value per share does not change. Consider Microsoft, with around $130 billion in liq- uid assets in 2019. The liquid assets are low risk and low return, so they have a high P/E (higher than for Microsoft’s operating assets). Paying out the liquid assets would reduce the proportion of high-P/E assets relative to lower-P/E assets, reducing the overall (weighted-average) P/E for Microsoft as a whole. In this section, we’ll show that the sophisticated investors who drive stock market values dig beneath a company’s accounting information to understand the underlying economic fundamentals. A classic example is the share price reaction to changes in inventory accounting by U.S. companies in the 1960s and 1970s. Because of rising price levels in these years, changing from first-in- first-out (FIFO) to last-in-first-out (LIFO) accounting decreased reported prof- its as well as taxable income. But the investor reaction reflected by the share price was typically positive, because investors understood that free cash flows would be higher as a result of lower taxes.13 Sometimes investors have difficulty detecting the true economic situation behind accounting information. For example, investors found it hard to assess the true risks and returns on capital of many financial institutions prior to the 2008 credit crisis because the financial reports were so opaque. Some com- panies, including Enron and WorldCom, misled stock markets by purposely manipulating their financial statements. But all managers should understand that markets can be mistaken or fooled for only so long. Sooner or later, share prices need to be justified by cash flows rather than accounting earnings. 13 G. Biddle and F. Lindahl, “Stock Price Reactions to LIFO Adoptions: The Association between Excess Returns and LIFO Tax Savings,” Journal of Accounting Research 20, no. 2 (1982): 551–588. MYThS abouT earnIngS 111 epS growth from Share repurchases Even though EPS is not a reliable indicator of value creation, many compa- nies still use it as a key measure of fi nancial performance and an important input for executive compensation. Not surprisingly, we fi nd that executives pursue share repurchase programs mainly because they believe the resulting EPS growth creates value for shareholders. But savvy markets see through such moves with a gimlet eye. One company managed to create strong growth in EPS while its net income was falling, simply by retiring its shares even faster. 14 When investors understood that business results were declin- ing, the company’s share price dropped by 40 percent relative to the overall market change. The empirical evidence is clear. At face value, there appears to be a cor- relation between shareholder value creation and the intensity of a company’s share repurchase program. But that is simply because companies with higher returns on capital and growth also tend to pay out more cash to shareholders. After we control for differences in growth and return on capital, no relation- ship is left between share repurchases and shareholder value creation (see Exhibit 7.10 ). 15 15 If companies could time share repurchases when share prices are truly low, they could create value for shareholders who do not sell. However, as we discuss in Chapter 33, most companies do not time repurchases effectively. 14 See O. Ezekoye, T. Koller, and A. Mittal, “How Share Repurchases Boost Earnings without Improving Returns,” McKinsey on Finance , no. 58 (2016): 15–24. EXHIBIT  7.10 Relationship between Share Repurchases and Shareholder Returns Effect of share repurchases on TRS,1    % –4 –2 0 2 4 6 8 20 15 10 5 0 –5 –10 Share-repurchase intensity,2 % Based on a sample set of more than 250 nonfinancial S&P 500 companies. 1 Effect of share repurchases on TRS is measured by residuals of multivariate regression. Variables are share-repurchase intensity and economic-profit growth. Economic-profit growth is a measure that combines earnings growth and return on capital (relative to cost of capital). This regression shows that the effect of share-repurchase intensity is not statistically significant. 2 Difference between EPS growth and net income growth used as proxy for degree of share-repurchase intensity. Source: Corporate Performance Analytics by McKinsey.