I will dive into the concept of Earnings per Share and how relying on it can hurt innovation.
EPS (Blog 5)
EPS stands for Earnings per share, and it is different than the other two financial tools (NPV and sunk costs) because it isn’t used to valuate a decision. It is a measure of how the company is doing in its entirety.
When understanding what EPS is, it’s important to note the difference between cash flow and profit. Cash flow shows the exact amount of a company’s cash inflows and outflows over a period of time. Profit is the revenue remaining after deducting business costs, which includes noncash transactions like depreciation. Profit is more representative of how the company is doing as a whole.
EPS is calculated as a company’s profit divided by the outstanding shares of its common stock. It indicates how much money a company makes for each share of its stock. A higher EPS indicates greater value because investors will pay more for a company’s shares if they think the company has higher profits relative to its share price. EPS is a metric many major companies take seriously and try to increase because “in theory” it means that company is more valuable to investors.
Christensen believe EPS is a third financial paradigm that leads established companies to underinvest in innovation for 2 main reasons:
1. Focusing on increasing performance metric can distract you from what really matters.
2. Increasing share price may hurt the value of a company by restricting the flow of cash available for investment.
While having a higher EPS is good and results from having high profits, it should not be as heavily focused on as it is today. Having a high EPS looks good to the public and for short-term stock prices, so managers are put under a lot of pressure to maintain and increase this metric. Some are even rewarded for improvements in share price. This is faulty because focusing on so much short-term performance often takes away from the long-term health of the company.
Furthermore, driving up share price doesn’t help the underlying value of the company and may hurt it by restricting the flow of cash available for investment. These shares prices can be easily manipulated and are by companies to appear profitable and have a strong public reputation. For instance, some companies will use excess cash to buy their shares back instead of spending it on innovation to make the company better in the long run. By buying these shares back, it decreases the number of outstanding shares in the market and boosts EPS up. Companies would rather seek immediate gratification than improve their long-term business which is a big problem.