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28 January 2019
Much has been written about the problems associated with the prevalence of short-term thinking in corporate America. As noted in a post from The Harvard Law School Forum on Corporate Governance and Financial Regulation, an academic study revealed that "three quarters of senior American corporate officials would not make an investment that would benefit a company over the long run if it would derail even one quarterly earnings report." (See this PubCo post and this article in The Atlantic.) Apparently, that was no joke. As reported in Forbes, for the first six months of 2018, companies in the S&P 500 spent $367 billion on stock buybacks—which can drive increases in quarterly EPS without increasing the underlying long-term economic value of the company—while capex totaled only $317 billion. ls there a way to engineer a course correction?
As reported in The Atlantic, a recent study has shown that, from 2015 to 2017, the restaurant industry spent 140% of its profits on stock buybacks, retail spent nearly 80% and food manufacturers spent almost 60% of their profits on buybacks. Across the board, public companies spent about 60% of their profits on buybacks during that period, leaving little for alternative uses of capital, such as long-term strategic investment in productive assets and R&D. (See this PubCo post.) The study then calculated the amount that various large companies could instead have increased worker pay and came up with raises of $18,000 a year per employee of certain retailers and $4,000 to $7,000 a year per employee of certain restaurant companies. The article observes that buybacks were actually prohibited as manipulative until Rule 10b-18 was adopted, and that several Democratic senators have previously introduced legislation targeting the practice of buybacks.
There are many points of view with regard to the causes of short-termism, with blame attributed to, among other things, executive compensation (see this PubCo post and this PubCo post), pressure from Wall Street to increase quarterly results (see this PubCo post), traders' compensation (see The Atlantic), the "legal underpinnings" of capital markets regulation and the business model and prevailing culture of the investment management industry (see this PubCo post), caselaw regarding directors' fiduciary duties (see this PubCo post), and, perhaps most significant, hedge-fund activism (see this PubCo post).
To deter short-termism, some have recommended that companies stop giving quarterly guidance, and some have advocated an end to quarterly SEC reporting (see this PubCo post, this PubCo post and this PubCo post)—a topic that would now be under consideration by the SEC if it were open. Now we have an academic offering a new theory: the solution is getting rid of the use of EPS altogether. In Is It Time to Get Rid of Earnings-per-Share (EPS)?, the author suggests that EPS is a primary driver of short‐term behavior, affecting stock repurchases, R&D investments, capital expenditures, employment and M&A deal structure. What's more, he concludes, the "practice of chasing EPS with changes in real investments appears to lead to long‐term underperformance and can significantly affect economic growth and welfare."
According to the author, evidence in the literature supports the concept of a nexus between the use of EPS targets and short-term behavior. For example, one study showed that the analysts' consensus EPS estimate was identified by 73.5% of CFOs as the most important performance target. In addition, he contends that there is significant evidence suggesting that firms decrease discretionary expenditures to meet EPS targets. For example, the accounting literature supports the idea that "there is a discontinuity in R&D growth right at the point at which reported EPS equals the consensus forecast; that is, firms that just beat the forecast have significantly lower R&D growth than those that just miss the forecast." A similar result occurs in connection with stock repurchases and capital expenditures, employment and R&D growth: the author asserts that "managers are willing to trade-off investments and employment for stock repurchases that allow them to meet analyst EPS forecasts." The author also contends that there is "[p]lenty of anecdotal evidence indicat[ing] that firms are concerned with EPS accretion and dilution when planning and executing an acquisition."
And it's not only consensus EPS estimates that are drivers of this behavior; for example, explicit EPS targets in incentive comp arrangements have also been shown to drive behavior, causing performance to "to cluster right at these compensation goals." Another study showed that companies "can also engage in real earnings management using price discounts to increase sales temporarily, or overproducing to reduce the cost of goods sold."
According to the author, these practices have a long-term impact: although it is difficult to establish "long-term effects of short-term actions," there is evidence in the literature that "suggests that the practice of chasing EPS with changes in real investments leads to long‐term underperformance, and thus is likely to be inefficient." As a result, the author advocates that EPS targets no longer be used.
To break the link between EPS targets and short-termism, one approach the author advocates is to eliminate EPS-linked compensation. According to the author, other performance measures are less susceptible to manipulation: there is "no clear evidence of performance manipulation to meet compensation targets that depend on sales and other measures of profits, such as EBITDA." However, addressing compensation targets is only part of the answer. That's because the pressure not to miss EPS targets—which can affect stock prices—is a factor in short-term thinking independent of compensation.
As a result, the author proposes that EPS be replaced with another "simple metric of performance that is easy to understand and that is relatively comparable across firms." As one possibility, the author suggests consideration of return on assets (ROA) as a measure, "probably the most common proxy for accounting performance in academic studies." ROA, the author contends, is not susceptible to performance manipulation through the same types of actions that companies take to meet EPS targets. If ROA is defined as operating income in the quarter, divided by assets at the beginning of the quarter, stock repurchases would not affect this measure.
However, ROA is not completely impervious to performance manipulation, given that R&D spending would reduce operating income. Consequently, the author also advocates that two other concepts be adopted. First, the use of multiple performance measures, such as ROA and revenues, may help to curb incentives for performance manipulation. Second, he advocates that analysts and companies focus on "forecasting ranges, rather than point estimates."
The author argues that elimination of EPS is preferable to eliminating earnings guidance because "empirical literature that studies firms that eliminated EPS guidance suggests that stopping guidance deteriorates firms' information environment and is not associated with increases in long‐term investment." Similarly, moving away from quarterly reporting could also decrease information available to analysts and the market, but does not, in his view, eliminate incentives to meet annual or semi‐annual EPS targets. Moreover, he argues, there is wide disagreement about the impact of hedge-fund activism on short-termism. But, in any event, giving more control rights to long-term institutional investors with the aim of mitigating short-termism may have unintended consequences, as some studies have shown that these shareholders may have "incentives that are misaligned with total value creation."
In conclusion, the author contends that EPS is "poor measure of firm performance." Nevertheless, he believes, the "financial markets and corporations are trapped into a 'bad equilibrium' in which EPS targets matter more than they should….As a consequence, managers incorporate EPS targets into corporate finance decisions, and end up focusing too much on the short‐term at the expense of long‐term investments and growth." How do we upset this bad equilibrium? The low-hanging fruit, the author suggests, is the elimination of EPS-based comp. After that, the author maintains, the elimination of EPS could be addressed through teaching, research and other market action.
For further information on this topic please contact Cydney Posner at Cooley LLP by telephone (+1 415 693 2000) or email (email@example.com). The Cooley LLP website can be accessed at www.cooley.com.
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