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Price Earnings Ratios, Earnings-Per-Share, and Financial ManagementAuthor(s): John J. PringleSource: Financial Management, Vol. 2, No. 1 (Spring, 1973), pp. 34-40Published by: Blackwell Publishing on behalf of the Financial Management Association InternationalStable URL: http://www.jstor.org/stable/3665098Accessed: 15/09/2010 22:10

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P R I C E EARNINGS RATI OS,EARN NGS- PE RSHARA N D FINANCIAL MANAGEMENT

JOHN J. PRINGLE

Dr. Pringle received his PhD degree from Stanford University andpresently is Associate Professor of Finance at the University of NorthCarolina at Chapel Hill. He was a vice president of the North CarolinaNational Bank for several years prior to assuming his present positionand earlier was with the Cost Analysis Department of the RANDCorporation. He is co-author of articles that have appeared in theJournal of Businessand the Journal of Finance.

T he price/earnings ratio is cited often in the finan-cial press and elsewhere as an important considerationin several areas within financial decision-making, butespecially where common stock is concerned [4, 13,19]. Where the decision is a choice between securitytypes, the higher the P/E ratio, so the argumentgoes, the more attractive is equity. When an invest-ment or the acquisition of another firm is involvedalso, the higher the P/E ratio, the more easily ac-cepted is the commitment of funds. In short, whenthe P/E ratio is high, equity is more attractive asa means of raising funds, and investments financedby equity are more attractive than otherwise mightbe the case.

This focuses attention on the wrong criterion. The"P/E view" can lead to confusion of the effects ofinvestment decisions with those of financing decisions,and often will lead to incorrect policy decisions.Under most circumstances, the magnitude of the P/Eratio is not relevant.

EPS vs. Market Value

Those who argue that a high P/E ratio favors theuse of equity usually do so on grounds that the

higher the P/E, the fewer the number of shares thatmust be issued for a given volume of funds and theless the resulting dilution of earnings per share(EPS).

As a criterion for financial management decisions,maximization of EPS has two important shortcomings:(1) It ignores the time value of money, and (2) itdoes not take account of risk.

With regard to the first point, which EPS is to bemaximized-this year's EPS? Next year's? Long-runEPS? Because most financing and capital investmentdecisions are multi-period in character, maximizingEPS is ambiguous because of inter-period trade-offs.

With regard to the second point, the EPS criteri-on does not take account of the quality of earnings,i.e., their degree of uncertainty. If Project A hashigher expected earnings than Project B, it would bepreferable always to B under the EPS criterion, eventhough it might be far more risky.

A criterion that solves conceptually both of theabove problems is that of maximizing the marketvalue of the firm's equity. Market value includes thediscounted value of all future earnings and thus takesaccount of effects over all relevant future periods.Trade-offs between periods are handled via dis-counting. Market value also deals with the problem

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of risk because, since investors are risk-averse, valueis a function of return and risk.

Distant Benefits

The superiority of the market-value rule over theEPS rule on theoretical grounds is widely recognized[9, 12, 16, 17]. In practice, however, when the mar-ket value rule is to be used operationally, a difficultyoften arises in connection with the linkage betweenvalue and current market price.

The market value criterion can lead to acceptanceof capital investment projects whose benefits are farin the future, with little, or even adverse, effects onnear-term EPS. Distant benefits are difficult to eval-uate, particularly since it often is difficult for afirm's management to promulgate information. Theresult of applying the market-value criterion could bea decline in near-term EPS and, to the extent thatnear-term EPS is used by the market as a guide tolong-run prospects, to a decline in stock price ratherthan to the rise predicted by theory. Furthermore,such a decline in price could imply that the stock ismore volatile, and hence more risky, than is thefact.

But distant benefits eventually come home to roost.A firm that maximizes value is likely to be worthmore in the future than a firm that follows an EPS-maximizing approach. IBM is a prime example of acompany with the kind of long-range outlook impliedby the market-value criterion (witness its historicalpreference for leasing of its products over outrightsale), and IBM shareholders have received consistentlysuperior returns. There may be a disparity betweenthe long run required by the market-value criterionand the length of a decision-maker's incumbency.However, the market-value criterion, consistently ap-plied in the long term, will provide a higher totaldollar return to shareholders than any other criterion.

Is the Stock Correctly Priced?

A critical assumption underlying the market-valuerule-and much of the analysis of this paper-is that

stock prices are determined in a competitive securitiesmarket at equilibrium based on information correctlyevaluated. At the heart of the matter, and at theheart of much disagreement between academicians andpractitioners, is an assumption with respect to the ef-ficiency of stock market processes. Many academi-cians, assume that the stock market closely approxi-mates an efficient market, i.e., that market prices atall times "fully reflect" all available information. Insuch a market, current price is the best unbiased es-timate of true intrinsic value-not necessarily an ac-

curate estimate, but unbiased in that true intrinsicvalue is as likely to be below current market price asabove [5].

Academicians point to an impressive body of evi-dence gathered over the last ten years that supportsthis argument [2, 3, 5, 7]. Of particular significanceto the argument is that using only publicly availabledata, professional portfolio managers have been unableto earn above-average returns by identifying securitiesincorrectly-priced [11-Ch. 8, 18, 20, 21].

Practitioners, on the other hand, often view themarket as "irrational" with prices determined by non-economic considerations. They are not alone in thisview. None other than J. M. Keynes appears tohave viewed the market as essentially psychologicalas opposed to an economic phenomenon, suggestingthat the market is ". .. a game of Snap, of OldMaid, of Musical Chairs," with the players all awarethat ". .. it is the Old Maid which is circulating, orthat when the music stops some of the players willfind themselves unseated" [6, pp. 155-156]. (ThereKeynes also describes his well-known beauty-contestanalogy.) If it's really just a game of musical chairs,why should a financial manager worry about stockprice?

One can reconcile the economic and psychologicalviews by arguing that over the long run economicvariables prevail, while conceding that at timespsychology and emotion may be very important,e.g., at the peaks of speculative "bubbles" or duringperiods of "gloom" such as in May 1970. If pricesare a function of economic variables-cash flows,earnings and dividends-at least in the long run thecase for market value as a normative criterionremains valid.

If the market is "efficient" as academiciansclaim,and if in addition the market possesses all materialinformation, then management can assume that thestock is correctly priced. Clearly situations can, andoften do, exist wherein management has informationthat the market does not. Such situations probablyoccur most often in connection with investmentplans. However, as long as it is solely an investmentdecision-and no financing decision is involved-thenet present value rule still is the appropriate cri-terion. The presumption is that when complete infor-mation ultimately is communicated to the market,price will adjust and shareholders will reap the an-ticipated returns.

Where a financing decision is involved, the situationis different. To undertake a financing of any sort,but particularly an equity financing, at a time whenoutstanding securities are incorrectly priced, presentsobvious difficulties. However, because of reportingrequirements in connection with securities issues, it

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is unlikely that the problem will be caused by dif-ferences in information in the hands of managementvs. the market, as is often the case with investmentdecisions. Rather, a more likely situation in con-nection with a financing is one in which the marketpossesses all material information, but managementfeels that the market is not correctly evaluating itand that the stock is mispriced.

In the large majority of financing decisions, whereall material information necessarily must be com-municated to the market, the weight of the evidencesuggests that policies should be based on an assump-tion that information is or will be correctly evaluatedand current market price is an unbiased estimate ofintrinsic value. Even in a situation involving no his-torical precedents on which the market might basejudgments, there is no case for returning to currentEPS as a criterion for decisions. The shortcomings ofEPS for such purposes still remain.

Financing Decisions vs. InvestmentDecisions

Although not separable theoretically, investmentand financing decisions affect market value via funda-mentally different mechanisms. A clear understandingof these mechanisms is necessary in order to avoidconfusing the effects of investment decisions with thoseof financing decisions and the attendant risk ofpolicy errors. With regard to financing decisions,there are two basic questions at issue, optimal ma-turity (short-term vs. long-term funds) and optimaldebt/equity mix. The maturity question is a complexone and a subject in itself. Here we will assume thatthe maturity question is settled somehow and willconsider only the choice of debt vs. equity.

Leverage and Value

The two most important factors in determiningthe optimal debt/equity mix are (1) tax effects and(2) the risks and costs of bankruptcy. As leverageincreases, expected return and risk both rise. Riskto equity holders increases with leverage becauseoperating risk, though remaining constant in total,is borne by an equity base that grows smaller asleverage increases. In the absence of taxes and bank-ruptcy costs, Modigliani and Miller [8] demonstratedtheoretically that, in competitive financial marketspopulated by risk-averse investors, the increase inrisk as leverage rises exactly offsets the increase inexpected return. Hence, under such assumptions,the value of the firm is invariant with leverage.

With the corporate income tax and with intereston debt tax-deductible (but still assuming no bank-ruptcy), the value of the firm increases with leverage[9, Ch. 3 is a good discussion of tax effect of debt].The increase in the value of the firm represents atransfer from taxpayers in general to the share-holders of the firm. In competitive financial markets,this tax effect is by far the most important mech-anism by which leverage has a positive effect onvalue. For example, assuming no expected growthin sales and earnings, a perpetual life for the firmand a constant debt/equity ratio over that life, ata tax rate of 48% replacing a dollar of equity witha dollar of debt increases the value of the firm by48. Assuming less than an infinite life, the effectis less, but assuming positive growth, the effect isgreater. Regardless of the particular assumptions,the conclusion is the same: the tax benefit is verysignificant.

How much debt should be used? Is there a limiton the extent to which the tax benefit can be ex-ploited? The empirical evidence on this point is farfrom conclusive [9, 10, 16], but there is reason tobelieve that financial markets are sufficiently freeof large and systematic imperfections that, at lowlevels of debt, value rises with leverage primarilybecause of the tax effect. As leverage increases, therisk of bankruptcy at some point becomes material.It is necessary now to draw a distinction between therisk of bankruptcy, i.e., the probability of its occur-rence, and the costs of bankruptcy. Bankruptcy costsinclude real resource costs such as those of accoun-tants, lawyers, judges and, most importantly, under-utilized labor and facilities of the bankrupt firm, aswell as psychological costs to investors, creditors andmanagers.

As the risk of bankruptcy rises with leverage,there comes a point where the probabilistic cost ofbankruptcy outweighs the benefits of deductibilityof interest cost. At that point the value of the firmstops rising with leverage and the optimal debt/equityratio is reached. Pushing the debt ratio beyond theoptimum would result in a decline in value. Fortheoretical discussions of the effects of bankruptcycosts see [14] and [15].

In practice, the problems of determining optimalcapital structure are formidable indeed. However,the important point for our purposes here is that anoptimal debt/equity ratio does exist in principle, andthat it involves primarily a trade-off between taxeffects and expected bankruptcy costs. Thus, the choiceof debt vs. equity in any particular financing decisiondepends on the relation between the firm's existingdebt/equity ratio and its target (optimal) ratio. If theexisting ratio is below target, debt should be issued;



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otherwise, equity, or a combination of the twoshould be issued. In no event does the choice dependin any way on the firm's current P/E ratio.

It is worth noting that in practice a managementmay stop short of the debt/equity ratio that is op-timal for shareholders, i.e., that maximizes value.Shareholders through diversification can reduce the

impactof an individual

bankruptcyas far as their

own interests are concerned. A management, as faras its interests are concerned, e.g., continued employ-ment, cannot, and may have a lower tolerance forbankruptcy risks than do shareholders.

Interdependence of Financing andInvestment Decisions

In simplest terms, if maximizing the value ofthe firm is the objective, the correct action is toaccept a project if its expected rate of return exceedsits "cost of

capital," dependenton its riskiness and

also, because of the tax benefits of the use of debt,on the financing mix. Any project meeting this cri-terion will have a positive net present value, and itsacceptance will increase the value of the firm.

Optimal investment decisions thus depend in part onthe financing mix. The optimal financing mix in turndepends in part on the risk of bankruptcy, which de-pends in part on operating risk and, hence, on thefirm's investment decisions. Therefore, theoretically,the investment and financing decisions are interdepen-dent and must be considered jointly as a simultan-

eous system [12, Ch. 1]. In a long-range context,where a series of investment and financing decisionsare being considered in a growing company, the twosets of decisions become even more intertwined, anda dynamic-sequential ramework becomes appropriate.

Thus optimal investment and financing policiesdepend on a set of complex and interrelated factors,including expected operating returns and risks, taxrates, bankruptcy costs, and the length of the plan-ning horizon. The critical point for purposes of thisdiscussion is that, if market value is the decisioncriterion as it should be, the choice of debt vs.

equity does not depend in any way on the firm's cur-rent price/earnings ratio.

Policy Errors

If the P/E-EPS view is used in practice as thebasis for financial management decisions, what kindsof policy errors can result, and how serious arethey?

Confusing the Effects of Investment andFinancing Decisions

One major potential source of error is confusionof the effects of investment decisions with those offinancing decisions. If market value is used as thedecision criterion, the effects of the two types ofdecisions can be separated; if EPS is the criterion,the potential exists for confusion. Let us consider anillustration.

It sometimes is argued that the sale of equityaffects share value, and examples are cited of firmswhose market price moved either up or down uponthe announcement of a new equity issue. A price de-cline usually is explained as the result of anticipated"dilution" of EPS due to the new issue. However, itis not the issuance of new equity that causes theprice change. For example, assume that a firm'sstock is currently priced at $100 per share and thatthere are one million shares outstanding. The firmissues 100,000 new shares at $100 (ignoring flotationcosts) to raise $10 million. The $10 million in newcash goes into the till, and after the sale the valueof the firm still is $100 per share. The act of sellingequity itself does not affect value; the firm is worththe same per share the day after the sale as before.

Obviously, a critical element in the above argu-ment is whether, at the time of the financing, thestock is correctly priced. If it is not, then sale ofsecurities at an incorrect price clearly will affect thevalue of the holdings of existing (before the finan-

cing) security holders. Before the fact, at the timeof a financing decision, the critical question for man-agement is whether current market price is an un-biased estimate of true value. If so, then based onthe best information available at the time the act offinancing itself has no effect on value per share. Theweight of the evidence indicates that this is the safestassumption to make.

How then is the above argument reconciled withthe frequently observed phenomenon of a market

price change immediately following the announcementof an equity issue? There are two possible explana-tions:

1. If the market had anticipated a debt issuebecause it had assumed that management's targetdebt/equity ratio was above the current ratio, thenthe capitalized value of the tax subsidy alreadywould have been reflected in the stock price. Asurprise announcement of equity instead of debtlikely would cause a fall in stock price as the mar-ket revised downward its estimate of management'starget debt/equity ratio and eliminated the value ofthe associated tax benefit.

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2. Announcement of a financing decision oftenconveys information regarding investment opportun-ities. If the market interprets the announcement ofa new financing as a signal that management seeseven more attractive investment opportunities aheadthan previously had been anticipated, price may rise.If the market sees no such attractive possibilities,price may fall. In either event, the market is makingan assumption as to what management plans to dowith the proceeds of the issue. Thus it is the mar-ket's assumption regarding the investment decision,rather than the act of financing, that causes the pricechange. "Information effects" of this sort often aresignificant and can be misleading.

A clear understanding of the mechanisms bywhich investment and financing decisions affect valueand clear identification of the effects of the two de-cisions thus is necessary for good financial manage-ment. A management that concluded equity issuesthemselves cause price declines is likely to be ledeither to over-reliance on debt or to foregoing at-tractive investments. Either way, shareholders arethe losers.

Too Little Debt

Potential for error in setting capital structurepolicy also exists in the case of firms with high P/Eratios. Unswerving application of the P/E-EPS viewby such firms could lead to the use of too little

debt, at least as far as shareholders are concerned.It should be noted that the P/E-EPS view impliesthe use of the E/P ratio as a measure of the "costof equity capital." It is now widely recognized thatthe E/P ratio seriously underestimates the rate ofreturn required by equity holders in all but a fewspecial cases. When the after-tax cost of debt exceedsthe E/P ratio, substitution of debt for equity willlower EPS. If, for example, long-term debt costs 8%before income taxes at 50% and has an after-taxequivalent of 4%, this situation will exist for anyfirm with a P/E ratio above 25, i.e., E/P = 4%.The use of EPS as a decision criterion by such firmsthus is likely to lead to less than the optimal a-mount of debt, as measured by the correct criteriaof tax and bankruptcy effects. Shareholders are poorerby the amount of the tax valuation effect foregone.Equity appears to be "inexpensive" in terms of itsimpact on EPS, less "expensive" than in fact it is.One thus may question whether the no-debt or low-debt policies of some high-growth, high P/E firms-Polaroid is a good example- really are in theinterests of shareholders.

Too Much Debt

Conversely, the P/E-EPS view may lead a lowP/E firm to use too much debt. When the after-taxcost of borrowing is less than the E/P ratio, anincrease in leverage raises EPS. Equity appears to be"expensive" and debt relatively more attractive. Ifa firm is misled to the point of pushing debt beyondthe optimum, stock price may be depressed as in-vestors take account of bankruptcy risks and costs.The P/E ratio falls, E/P rises, and the bias increasestoward the use of still more debt.

Perhaps the best recent examples of firms thatmay have fallen into this trap are the airlines.Given their high operating leverage, one would expecttheir optimal debt/equity ratios to be below theaverage of all firms, yet airlines typically have beenamong the heavier users of debt. Pan American, ofU.S. airlines the one that has experienced perhapsthe

greatestfinancial difficulties over the

pastseveral

years, recently marketed still another issue of debt(Wall Street Journal, Jan. 18, 1973). Pan American's$75 million debenture issue is particularly interestingbecause of its "delayed conversion" feature, designed(according to the WSJ account) to "avoid an imme-diate dilution of its stock" and the necessity of "sel-ling equity below book value."

Examples can be found of other firms whosefinancing policies seem based first and foremost onthe principle of avoiding the sale of new equity.See, for example, the cases cited in [4], where such

a policy was nearly universal. If such a policy isnot to result in over-reliance on debt, curtailment ofinvestment would seem a likely outcome.

Mergers and Acquisitions

Another area with great potential for trouble isthat of mergers and acquisitions. Here it is oftenthe case that both an investment and a financingdecision are involved, and the potential for con-fusion is greatest. The argument often is made thata major reason for attaining a high P/E ratio is

to "improve the terms on which earning power canbe acquired." One way of "acquiring earningpower"is via acquisition, and the higher the P/E, the lowerthe number of shares that must be traded to acquirea given amount of earnings.

Obviously, it is true that the relative P/E ratiosof acquirer and acquiree do affect the EPS of thecombined enterprise. But EPS is the wrong criterion.What matters is the total market value of the stockbeing given up by the acquirer vs. the presentvalue of the future cash flows being acquired. If



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the acquisition can be made at a total price less thanthe discounted value of the cash flows, it is advan-tageous to present shareholders; if greater, it is dis-advantageous. The relative P/E ratios of acquirerand acquiree are not relevant to the decision.

Use of the P/E-EPS view as the basis for ac-quisition decisions can lead to the erroneous anddangerous conclusion that, the higher the acquirer'sP/E relative to that of the acquiree, the more intotal the acquirer can afford to pay. In a trans-action involving only equity under pooling-of-interestsaccounting, where the P/E of the acquirer is higherthan that of the acquiree, the EPS of the combinedenterprise always will exceed the EPS of the ac-quirer (without the acquisition). As long as near-term EPS increases, or at least is not diluted, theacquisition is deemed advantageous.

Such a view fails to consider the expected cashflows from the acquisition over time and fails tomeasure the present value of those flows againstthe required outlay. There is an implicit assumptionthat the former P/E of the acquirer will be appliedto the earnings of the acquiree. The outlay is noth-ing less than the market value of the stock the ac-quirer gives up, and if the future cash flows arenot of sufficient quality (referring to riskiness) andgrowing rapidly enough to justify the price paid,the effect cannot be other than a reduction in thevalue of the stock of combined enterprise. Thisreduction in value is the amount by which thepresent value of the cash flows from the acqui-sition falls short of the price paid. The effect maynot be readily apparent where the acquiree is verysmall relative to acquirer, but it is no less real, andthe cumulated effect of applying the P/E-EPS ap-proach over a number of acquisitions could be dis-astrous for the price of the acquirer's stock. Itwould be interesting to examine the conglomeratemovement of the 1960's in this light and to questionwhether the difficulties that some subsequently haveexperienced can be traced to the P/E-EPS viewpoint.

Forsaking Attractive Investments

The converse of this argument holds. A low P/Efirm using the P/E-EPS criterion might tend to pass

up investment projects or acquisitions that actuallyare in the interests of its shareholders. It is bymaking investments that firms create value andincrease returns to shareholders (the increase invalue due to the tax treatment of interest costsrepresents a transfer, not new value created).

If equity is called for and the firm decides againstthe investment and associated financing because the

P/E ratio is "too low" or because EPS will be"diluted," the effect in most cases will be detri-mental to shareholders. They will be poorer by thenet present value of the investment foregone.

Conclusions

The choice of debt vs. equity depends on wherethe firm presently is operating relative to its target(optimal) debt/equity ratio, which in turn dependsprimarily on a tradeoff between tax effects andbankruptcy costs. Investment decisions, includingacquisitions, should be judged on the basis ofthe net present value criterion. In the case ofneither financing decisions nor investment decisionsis the firm's current P/E ratio a relevant consider-ation.

This is not to say that a high P/E ratio isnot desirable. When only investment decisions areinvolved, actions that raise market value normallywill increase the P/E ratio, and the P/E ratiooften is a

goodindicator of the rate of growth in

earnings expected by the market. Where financingis involved, it is sometimes the case that an actionthat raises market value, and therefore is desirable,may simultaneously lower the P/E ratio if cur-rent earnings rise percentage-wise more than price.An example of such an action is an increase inleverage via substitution of debt for equity. To theextent that a high P/E ratio indicates that manage-ment is doing a good job of maximizing marketvalue, it is desirable, but a high P/E ratio shouldnot be considered desirable because it permits raising

equity capitalmore

"cheaply"or making nvestments

on more favorable terms.

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REFERENCES

1. Edward I. Altman, Corporate Bankruptcy in America,Lexington, Massachusetts, Heath Lexington Books, 1971.

2. Richard A. Brealey, An Introduction to Risk andReturnfrom Common Stocks, Cambridge, Massachusetts,M.I.T. Press, 1969.

3. Richard A. Brealey, Security Prices in a CompetitiveMarket, Cambridge, Massachusetts, M.I.T. Press, 1971.

4. Richard A. Brealey, Strategy for Financial Mobility,Homewood, Illinois, Richard D. Irwin, Inc., 1969.

5. Eugene F. Fama, "Efficient Capital Markets: A Re-view of Theory and Empirical Work," Journal of Finance(May 1970), pp. 383-417.

6. J.M. Keynes, The General Theory of Employment,Interest and Money, New York, Harcourt, Brace andWorld, Inc., 1965.

7. Michael C. Jensen, "Capital Markets: Theory andEvidence," Bell Journal of Economics and ManagementScience (Autumn 1972), pp. 357/398.

8. Franco Modigliani and Merton H. Miller, "The Costof Capital, Corporation Finance, and the Theory ofInvestment," American Economic Review (June 1958),pp. 261-297.

9. Alexander A. Robichek and Stewart C. Myers, OptimalFinancing Decisions, Englewood Cliffs, New Jersey, Pren-tice-Hall, Inc., 1965.

10. David F. Scott, Jr., "Evidence on the Importanceof Financial Structure," Financial Management (Summer1972), pp. 45-50.

11. William F. Sharpe, Portfolio Theory and CapitalMarkets, New York, McGraw-Hill, 1970.

12. Ezra Solomon, The Theory of Financial Manage-ment, New York, Columbia University Press, 1963.

13. Joel M. Stern, "Let's Abandon Earnings Per Share,"Wall Street Journal (December 18, 1972).

14. Joseph E. Stiglitz, "A Re-Examination of theModigliani-Miller Theorem," American Economic Review(December 1969), pp. 78-93.

15. Joseph E. Stiglitz, "Some Aspects of the PureTheory of Corporate Finance: Bankruptcies and Take-Overs," Bell Journal of Economics and ManagementScience (Autumn 1972), pp. 458-482.

16. James C. Van Home, Financial Management andPolicy, 2nd ed., Englewood Cliffs, New Jersey, Prentice-Hall, Inc. 1971.

17. J. Fred Weston and Eugene F. Brigham, ManagerialFinance, 4th ed., New York, Holt, Rinehart andWinston, Inc., 1972.

18. Martin E. Zweig, "Darts, Anyone?", Barron's (Feb-ruary 19, 1973).

19. "Are The Institutions Wrecking Wall Street," BusinessWeek (June 2, 1973), pp. 58-66.

20. "Still An Inexact Science," Fortune (March 1972),p. 144.

21. "More Money Managers Now Aim Just to MatchPopular Market Averages," Wall Street Journal (June 7,1973), p. 1.


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