Research Note: The Deception of Earnings Per Share Growth
Executive Summary
Earnings per share growth represents one of the most misleading performance metrics in corporate finance, as it ignores the capital base expansion that automatically produces higher absolute earnings through retained earnings reinvestment. This research note examines why return on equity provides the only honest measure of management's economic performance and how companies manipulate investor perception through meaningless EPS metrics while destroying shareholder value through poor capital allocation.
The Mathematical Deception of EPS Growth
Most companies celebrate "record" earnings per share without acknowledging that retained earnings automatically increase the capital base, making EPS growth as mechanically predictable as compound interest in a savings account. A dormant savings account earning 5% annually will produce "record earnings" every year through pure compounding, requiring zero skill, effort, or economic value creation from any manager. Similarly, companies can generate impressive EPS growth simply by retaining all profits and reinvesting them at any positive return, even if that return significantly trails the cost of capital or alternative investment opportunities. This mathematical reality means that EPS growth tells investors nothing about management's ability to create value, operational efficiency improvements, or competitive position strengthening. The metric becomes particularly deceptive during inflationary periods when nominal earnings rise while real returns on capital decline, allowing management to tout growth while actually destroying purchasing power-adjusted returns for shareholders.
Return on Equity as the Superior Performance Measure
Return on equity provides the only honest assessment of management performance by comparing earnings to the capital employed to generate those results, effectively asking whether managers are creating value above what shareholders could achieve through passive investment alternatives. Berkshire's 19% return on equity in 1977 significantly exceeded American industry averages and represented genuine value creation, despite the seemingly modest context that 37% EPS growth required a 24% increase in beginning equity. This metric forces management accountability by revealing whether earnings growth results from skillful capital deployment or simply from accumulating more assets, distinguishing between value creation and value destruction through capital misallocation. ROE also enables meaningful comparisons across companies of different sizes and capital structures, as it normalizes for the scale differences that make absolute earnings comparisons meaningless. The metric becomes particularly powerful when tracked over multiple business cycles, revealing which management teams consistently generate superior returns regardless of economic conditions versus those dependent on favorable environments.
The See's Candies Example of Capital Efficiency
See's Candies exemplified extraordinary capital efficiency by tripling pre-tax earnings from $4.2 million in 1972 to $12.6 million in 1977 with minimal additional capital investment, demonstrating how superior businesses generate wealth through pricing power rather than capital accumulation. This performance created genuine economic value because the earnings growth required virtually no incremental shareholder investment, meaning every additional dollar of profit represented pure wealth creation rather than the mechanical result of deploying more capital. The candy company's ability to raise prices faster than costs while maintaining market share illustrated how branded consumer goods with customer loyalty can compound returns without proportional capital requirements. Such businesses contrast sharply with capital-intensive industries where earnings growth necessitates massive reinvestment, often destroying value when returns on incremental capital fall below the cost of capital. The See's model demonstrates that the highest-quality businesses grow earnings through operational leverage and pricing power rather than through the financial leverage of simply deploying more shareholder capital at mediocre returns.
The Reinvestment Rate Trap
Companies with poor returns on incremental capital destroy shareholder value even while showing impressive EPS growth, as they compound capital at rates below what shareholders could achieve through alternative investments or dividends. This reinvestment trap particularly afflicts capital-intensive industries where growth requires massive incremental investment, meaning that each dollar of retained earnings generates less than a dollar of present value for shareholders. Management teams often fall into this trap by mistaking growth for value creation, pursuing expansion projects that boost revenues and earnings while generating inadequate returns on the additional capital required. The problem becomes self-reinforcing as larger capital bases require ever-increasing absolute earnings to maintain returns, leading to a treadmill effect where companies must constantly find new investment opportunities to avoid declining performance metrics. Shareholders would benefit more from dividend distribution when management cannot identify investment opportunities exceeding their cost of capital, but agency problems often prevent such rational capital allocation decisions.
Industry Context and Capital Requirements
Different industries exhibit vastly different relationships between earnings growth and capital requirements, making ROE comparisons particularly valuable for identifying businesses with sustainable competitive advantages versus those dependent on continuous capital injection. Asset-light service businesses and branded consumer goods typically require minimal incremental capital to support earnings growth, allowing most profits to flow directly to shareholders through dividends or share repurchases. Conversely, utilities, manufacturing, and commodity businesses often reinvest 60-80% of earnings just to maintain competitive position, meaning that apparent earnings growth may actually represent value destruction if returns fall below capital costs. Technology companies occupy a middle ground where initial development requires significant investment but subsequent scaling can generate enormous returns on incremental capital through software distribution and network effects. The critical insight is that investors must evaluate earnings growth within the context of industry capital requirements, favoring businesses that can grow without proportional capital increases over those trapped in constant reinvestment cycles.
Key Metrics from Berkshire's 1977 Performance
Return Measurement: 19% ROE vs. 37% EPS growth requiring 24% equity increase Capital Efficiency: See's Candies tripled earnings ($4.2M to $12.6M) with minimal new investment Industry Comparison: ROE significantly exceeded American industry averages Growth Quality: Insurance premium growth from organic expansion rather than capital injection Investment Returns: Portfolio generated substantial returns without increasing share count
Bottom Line
Sophisticated investors should focus exclusively on return on equity trends over multiple business cycles, ignoring earnings per share growth entirely unless accompanied by stable or improving capital efficiency metrics. Corporate boards must restructure executive compensation to reward ROE improvements rather than EPS growth, preventing management from destroying value through capital-intensive expansion that boosts absolute earnings while reducing per-dollar returns. Portfolio managers evaluating investment opportunities should prioritize businesses demonstrating consistent ability to grow earnings without proportional capital increases, particularly branded consumer goods, asset-light services, and technology companies with scalable business models. Value investors seeking undervalued opportunities should specifically target companies with temporarily depressed ROE metrics due to cyclical factors rather than structural problems, as these situations offer the greatest potential for multiple expansion when normal returns resume. The only investors who should accept low-ROE situations are dividend-focused strategies seeking stable cash flows from mature businesses, but even these strategies should demand higher dividend yields to compensate for management's inability to reinvest capital productively.