In this video we are talking about Earnings Per Share and I am going to tell you the problem with this metric. Not many people talk about the problems of Earnings Per Share. But it is just like any other financial metric. There are good things about it, but also shortcomings. If you take the time to think through the concept of Earnings Per Share, it is going to help you in your career. Watch now!
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In my experience in the business world, Earnings Per Share is the most discussed financial metric. Everyone talks about it. The crazy thing is that I have never talked about Earnings Per Share on this channel. I have made a ton of videos, but have never discussed Earnings Per Share. The reason is because of the problems with it. I think it is often a misleading metric.
Let us start by talking about the definition. The point of Earnings Per Share is it is supposed to give you a simple metric to gauge the performance of a company. It is a very simple calculation: Net Income / Number of Shares. It describes the amount of income that is allocated to you as a shareholder. So if you own 1% of the stock, you have the right to 1% of the earnings if it is paid out as a dividend. This is used very frequently by stock investors as part of the P/E ratio to determine the price of stocks. The benefit of Earnings Per Share is it is simple, quick and easy quantitative metric you can use to judge a company.
The problem with Earnings Per Share is it emphasizes short term pay-outs to investors. Every quarter, a company releases financial statements. On those financial statements is Earnings Per Share. Earnings Per Share is a key metric that drives real life business decisions, sometimes with the wrong result. It drives short term investor gains, over long-term business performance.
The point of Earnings Per Share is that it is a simple, quick metric. You are using a very simple metric to evaluate a complex organization. Life is more complicated than that. Not every business decision has a direct correlation with Earnings Per Share. In fact, most do not. This causes a lot of confusion.
In my opinion, in the business world today, this is the greatest paradox of our time. Companies are judged by Earnings Per Share, but Earnings Per Share does not drive most business decisions. And I will give you a simple example: Corporate Giving. Most corporations engage in community service programs, volunteer programs, and corporate donations. But if you use Earnings Per Share to guide your decision, you would never participate in any Corporate Giving. You are literally giving away the company’s money. You are supposed to be incre asing Earnings Per Share, not giving the money away. How do you rationalize corporate giving?
This is just one example, but the paradox does not stop there. There are examples throughout your business. When you are a business leader, you have a number of places you can invest your money.
Places to invest:
- Research & Development
Only one of these five places will increase your Earnings Per Share in the short term. Ultimately, investments in the other areas should increase your Earnings Per Share in the long-term, at the expense of your investors in the short term.
This conflict between the short-term and long-term is a real conflict you are going to face in the day to day operations of your business. I am making this video for business leaders out there who are struggling to make decisions on how to run their company. Here is what happens. When you go to business school in America, they pound it into your head that your responsibility is Earnings Per Share. You have a legal responsibility to maximize returns to your shareholders. They can sue you if you do not represent their interests. They repeat this over and over again: Earnings Per Share, Earnings Per Share, Earnings Per Share. When you get out of school and become a business leader, you are sitting behind your desk and you are making a decision. You know you should be taking care of all your stakeholders, like giving your employees training. But you end up with this huge conflict in your head thinking you are supposed to take care of your investors first. You think your responsibility is Earnings Per Share.
Let me offer you a different perspective. Your responsibility IS NOT to take care of the investment bankers. The bankers can take care of themselves. Your responsibility is to be a business leader. You are there to look at all your stakeholders and determine what is the best investment for the long-term. The right answer might decrease your Earnings Per Share in the short term, so you can have greater earnings in the long-term.
For all you business leaders who are struggling with decisions, you have to realize something. The economic system in America is skewed. It is skewed to favor bankers. This has to do with the history of the banking system, and how America developed. And I am not saying it is all bad. What I am saying is you should not judge a company based on a metric that is skewed to favor bankers in the short-term.
We all know this is true. I have to give business schools credit for teaching opposing viewpoints. Business schools teach that it is important to take care of your employees, and take care of your community. What business schools do a poor job at is resolving the conflict between these two ideas. They set up the paradox between corporate giving and earnings per share, but do not resolve it. If you are a business student right now, I am betting you are struggling with this. You have one teacher preaching Earnings Per Share, and you have another teacher telling you to take care of your community. Well who is right? What are you going to do when you get out into the workforce and you have to make these decisions? I am going to help you out, and tell you what to do. You need to be a business leader. It is your job to do the right thing for your company.
What we need to do is connect the dots between these opposing viewpoints by doing two things:
- Recognize multiple stakeholders in decisions
- Recognize EPS is a valuable but imperfect metric
Earnings Per Share does have a role to play in understanding your business. My hope is that we use this metric in a very thoughtful way. In business, your decisions impact the real lives of all sorts of stakeholders. Your goal should be to make everyone’s life better off, and generate long-term sustainable success.
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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.