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 potentially 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 any positive return 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 available to shareholders. 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 impressive 37% EPS growth requiring a 24% increase in beginning equity to achieve. 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 tailwinds.
The See's Candies Example of Exceptional 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 and operational leverage 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 at mediocre returns. 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, contrasting sharply with capital-intensive industries where growth necessitates massive reinvestment. Such businesses represent the holy grail of investing because they can grow earnings through operational improvements, market expansion, and pricing power rather than through the financial engineering of simply deploying more shareholder capital at adequate returns. The See's model demonstrates that the highest-quality businesses create value through competitive advantages and execution excellence rather than balance sheet expansion.
The Capital Allocation Challenge
The fundamental challenge facing corporate management is identifying investment opportunities that generate returns exceeding the cost of capital, as retaining earnings for reinvestment at inadequate returns destroys shareholder value even while producing impressive EPS growth statistics. Companies with poor returns on incremental capital would serve shareholders better by distributing earnings through dividends or share repurchases, allowing investors to deploy capital in higher-returning alternatives rather than accepting management's suboptimal allocation decisions. This principle explains why mature businesses in declining industries often trade at discounts to book value despite showing consistent earnings growth, as markets recognize that retained earnings compound at rates below shareholder opportunity costs. The reinvestment decision becomes particularly critical during periods of limited growth opportunities, when management's ego and empire-building tendencies often override economic logic in capital allocation choices. Berkshire's approach of retaining earnings only when they can generate returns significantly exceeding market alternatives represents the gold standard for shareholder-oriented capital allocation.
Industry Context and Competitive Dynamics
Different industries exhibit vastly different relationships between earnings growth and capital requirements, making ROE analysis essential for distinguishing between businesses that create value through growth versus those that destroy value despite impressive earnings trajectories. Asset-light service businesses, branded consumer goods, and technology companies with network effects typically require minimal incremental capital to support earnings growth, allowing most profits to compound for shareholders through either reinvestment at high returns or distribution for redeployment elsewhere. Conversely, utilities, manufacturing, and commodity businesses often must reinvest substantial portions of earnings just to maintain competitive position, meaning that apparent earnings growth may represent value destruction if returns fall below capital costs. The insurance industry occupies a unique position where premium growth generates float that can be invested at market returns, essentially allowing the business to grow without requiring shareholder capital while providing additional investment assets for wealth creation. Understanding these industry dynamics enables investors to identify businesses capable of genuine value creation through earnings retention versus those better served by capital distribution to shareholders.
The Inflation Impact on EPS Metrics
Inflation particularly distorts EPS growth metrics by allowing companies to report impressive nominal earnings increases while actual economic performance deteriorates in real terms, making ROE analysis even more critical during periods of monetary debasement. During the 1970s, many companies reported record earnings growth while their ROE declined due to inflation's impact on replacement costs, working capital requirements, and the real purchasing power of profits. This phenomenon demonstrates why investors must focus on real returns rather than nominal growth, as inflation can mask deteriorating business economics behind impressive absolute earnings numbers. The problem becomes compounded when companies celebrate EPS growth that merely keeps pace with inflation while failing to generate real wealth creation for shareholders, effectively presenting monetary illusion as management success. Berkshire's emphasis on ROE during this inflationary period provided honest assessment of economic performance adjusted for the capital required to generate results, revealing true value creation despite potentially modest nominal growth rates.
Key Metrics from Berkshire's 1977 Performance
Return Measurement: 19% ROE versus 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: Berkshire's ROE significantly exceeded American industry averages Growth Quality: Insurance expansion achieved through retained earnings rather than equity dilution Value Creation: Portfolio generated $74 million unrealized gains while maintaining high operating returns
Bottom Line
Sophisticated investors should focus exclusively on return on equity trends over multiple business cycles, completely ignoring earnings per share growth unless accompanied by stable or improving capital efficiency metrics that demonstrate genuine value creation rather than mechanical accumulation. Corporate boards must restructure executive compensation systems to reward ROE improvements and penalize capital misallocation, preventing management from destroying shareholder value through growth-oriented strategies that boost absolute earnings while reducing per-dollar returns on invested capital. Portfolio managers evaluating investment opportunities should prioritize businesses demonstrating consistent ability to grow earnings without proportional capital increases, particularly asset-light service companies, branded consumer goods with pricing power, and technology businesses with scalable competitive advantages. 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 persistently low-ROE businesses are dividend-focused strategies seeking stable cash flows from mature operations, but even these strategies should demand higher dividend yields to compensate for management's demonstrated inability to reinvest capital at adequate returns for long-term wealth creation.