EPS, or Earnings per Share, is a determinant of shareholders’ wealth and indicates ownership on the company’s earnings (that’s why it’s attributable to the common stock) for every share / stock owned by an investor.

When it comes to making an investment decision of a company’s stock, the Price to EPS multiple (P/E Multiple) plays an important role and is a key indicator since it reflects a company’s earnings not just at the operating level, but beyond that level. The earnings at the EPS level factors in the company’s operations, debt servicing cost (interest), and the reward / penalty emanating from business decisions taken by a company’s management that translates into extraordinary gains / losses. All of these goes as a determinant to shareholders’ wealth owned by the owners of the common stock, and, therefore, places a lot of relevance to EPS.

When an investor agrees for a price of an underlying security / asset based on the attractiveness of the multiples (price/earnings), it’s seldom known if those numbers are sitting on the top of an active volcano. Since the Balance Sheet, other than the mark-to-market securities, is represented in book value, the movement in the fair value of the assets never gets captured in the EPS, which reflects the shareholders’ wealth and hence the willingness of an investor to buy the security at a quoted multiple in order to participate in the firm’s wealth creation story. Having said that, there are possibilities that the other side of the story may be risky enough to not only more than offset the potential gains in such investments, but significantly erode the capital invested by an investor.

So, Is The Reporting Methodology of Financial Statements Falling Short of Presenting a True Reflection of EPS?

As far as trading securities are concerned, it is shown at the fair value using the ‘Mark-to-Market’ method and not at the acquisition value throughout the holding period. The underlying rationale is that the investors/stakeholders should know what the balance sheet is really worth, and how’s their wealth position changing because of the movement in the fair value of such trading assets. But when it comes to certain categories of fixed assets (land and building / facilities) it is always shown at the book value (net of accumulated depreciation) even if the property is in prime location, whose fair value could be far higher than the price it was acquired; or even the HTM category investments that is recorded at amortized cost so that the carrying value is the par value. This could mean one of the following is likely to happen for the existing and potential new investors:

1. If there is a fair value gain of the assets, the existing investors (who are shareholders) are deprived of the opportunity of reaping that benefit in terms of capital appreciation (given everything else equal), and the potential new investors would actually enter at a relatively lower premium since those benefits would not be reflected in the P/EPS multiple
2. If there is a fair value loss of the assets, the existing investors (shareholders) continue to enjoy the market premium which otherwise would have eroded their earnings, and the potential new investors would have to pay the price since such losses would not be captured in the EPS, and, therefore, will end up paying a relatively higher premium

At this juncture, I would like to put forward two important case examples in two different parts of the globe that will highlight the issues of not capturing the asset value in EPS –

Case Example 1: The Acquisition of Bear Stearns by JP Morgan

The date March 15, 2008 is an historic date in the global financial meltdown saga. The announced acquisition value of $2 per share totaling ~$236 million baffled almost every person on earth to figure out how a global bank gets acquired at such a valuation. This deal was announced on a Sunday under the pressure from Federal Reserve – the objective of the Fed was clear that the announcement should happen before the Asian markets opens on Monday. While Bear Stearns had its own fundamental problems in terms of sub-prime mortgage portfolio and liquidity drying up, it was seldom reflected in the income statement for an investor to decide if it’s the time to exit. To everybody’s disbelief, Bear Stearns’ stock closed at $30 a share at NYSE on that Friday (March 13, 2008, the last trading day before the acquisition announcement was made two days later on Sunday). What’s even more shocking is that one of the brokerage houses initiated coverage on Bear Stearns and gave a buy rating on the stock the same Friday. Therefore, two things were absolutely clear:

1. The closing stock price of $30 a share haven’t reflected the erosions in the Balance Sheet fair value; else how would the $2 a share value get justified
2. The brokerage house giving a buy rating on the stock could not figure out that the assets were wiped away, and that the shareholders’ wealth is lost

At the end of the day, the poor investors (all those who bought the company’s share at $30 per share) were trapped for no fault of theirs, and even before the next trading session their capital was eroded by more than 93%. The closing price of the stock on that Friday would not have been $30 a share if the Balance Sheet was reported at fair value. Now the bigger question is if the whole of Bear Stearns was really worth $2 a share? The sub-prime mortgage portfolio was $2 billion of the total mortgage portfolio of $33 billion of an entity having ten offices in United States and nine international offices globally. So how does it get valued at ~236 million when the market worth – according to one of the shareholders – of just their corporate headquarters at Madison Avenue in New York was ~$8 billion (leave alone the value of other eighteen offices)? Therefore, the fair value of the Balance Sheet assets was never considered in the shareholders’ earnings, else there would have been enough indications for shareholders to exit and prevent their capital from getting eroded.

Case Example 2: Black Monday – Metal Meltdown

There was a meltdown of the metal stocks on Monday, May 13, 2013 in the Indian bourses owing to one of the leading producers of steel (Tata Steel) announcing a $1.6 billion of goodwill impairment due to loss of value of Corus that it acquired in October 2006 and other overseas assets in Thailand and South Africa. These assets went bad due to sluggish demand for steel across major overseas markets leading to asset markdown / impairment. This is again a classic example of assets not being shown at fair value, the price of which was paid by the shareholders in terms of significant wealth erosion. It is hard to believe that this loss of value in assets happened overnight. These losses were getting accumulated but was never reported in the earnings thereby trapping all those investors (assuming there were no insider information) who believed in the company and was investing until the previous Friday prior to the announcement. Two things come out of this case example if the fair value of the assets was reported and reflected in the EPS:

1. The existing investors / shareholders would have got the opportunity (in terms of early signs) to exit and protect their capital
2. The new investors would have actually paid a realistic multiple that the company’s stock deserved to get

The above would have prevented overnight erosion in shareholders’ wealth since the EPS would have reflected the true picture, and the market prices would have adjusted accordingly. Consider the shock the investors may have got who believed in the fundamental strength of the company and invested on the previous Friday based on an inflated EPS, which was not reflecting the erosion in asset value.

Key Takeaways:

The inference that could be drawn from the above two case examples, if the assets are reported at fair value, are more than one –

1. It helps in preventing sudden erosion of wealth, since the market price would keep adjusting on a continuous basis to the movement in the fair value of the assets
2. When there is a gain in fair value, not only does it rewards its existing shareholders in terms of capital appreciation but also demands the right premium from new shareholders emanating from such gains
3. When there is a loss in fair value, not only does it give an exit opportunity to its existing shareholders and prevent capital erosion, but also provide transparency to the new investors to enter at a multiple it should be paying

So Why Should an Investor Not Look at P/EBIT Instead of P/E?

A question may arise that why should one not look at the operating level multiples since that’s the true reflection of a company’s core operations and the fact that the numbers are engineered / re-engineered below the operating line items. I would argue that the underlying objective to have Balance Sheet reported its assets in Fair Value is capital protection and wealth maximization. It should give an investor the ability to enter / exit an underlying security based on its true worth and informed decisions. If the assets are getting eroded and the shareholders’ earnings do not get adjusted, it would lead to victimizing of the investors (since he will be trapped) in terms of wealth erosion. Therefore, benchmarking an investment decision based on P/EBIT multiple would not be prudent since anyways it would not have reflected the movement in the fair value of the assets, thereby defeating the very purpose of safeguarding the shareholders’ wealth.

The Ideal Way Forward in Making Investment Decisions

A weighted average methodology appears to be the safest bet as it factors in all positive and negative of a company’s fundamentals, assuming Balance Sheets would be reflected at Fair Value. The following methods should be considered:

1. P/E Multiple – On the presumption that the multiple would reflect the fair value of the assets, current and 1-year forward multiple would be a fair reflection of the price of the underlying security
2. Income Approach using perpetual growth model
3. Income Approach using Exit EBITDA multiple
4. Market Multiple Comps using Guideline Public Companies comparable
5. Precedent Transaction Comps

By applying weights to each of the above methods, a final weighted average valuation of the underlying security can be derived. The only caution that needs to be exercised is that one has to ensure that the equity value arrived by each of the above methods is in similar range, which would be an acid test of an apt valuation, with the only exception that the equity value arrived by precedent transaction comp method could be higher than the range of the other methods. This is because of the control premium that gets built in certain transactions.