Note: Please read the disclaimer. The author is not providing professional investing advice.
I’m still working my way through the latest edition of Burton Malkiel‘s classic A Random Walk Down Wall Street. He gives an interesting – no, disturbing – example of how a company’s earnings growth rate can be manipulated through the creation of a conglomerate.
Generally as earnings increase, so to does a company’s stock price. When screening for stocks, a company can look very attractive if its historical earnings show a steady annual increase. And most investors don’t so much examine absolute earnings, but rather earnings per share or EPS.
And as it turns out, it’s easy to manufacture a growth in EPS, even if earnings themselves are not growing at all, by forming conglomerates.
A Tale of Two Companies
In his book, Malkiel gives us the following example of EPS growth fabrication. We start with 2 separate companies that have the following properties:
So both companies have the same number of shares in circulation and both have earnings of $1M per year. However, as is often the case, the flashy technology company commands a higher price-to-earnings ratio (P/E) than the less exciting candy business.
An Offer They Can’t Refuse
Company A makes Company B an irresistible wager. It offers to absorb Company B into Company A to form a conglomerate by giving B’s shareholders 2 Company A shares for every 3 of their Company B shares.
So Company B’s shareholders will receive 133,333 shares of A for their 200,000 shares of B.
Why so irresistible?
Compare what Company B is worth according to the stock market, versus the market value of the shares that Company A is offering in exchange.
(P/E x EPS x Shares)
Which deal would you choose?
So Company A prints up 133,333 additional shares and gives them to Company B’s shareholders. The merger is complete.
Now assume that the earnings of both A and B stay exactly the same, just as they were before the merger. The conglomerate now reports earnings of the same $1M + $1M = $2M, but earnings per share has increased from $5 before the merger to $6 now…
Clearly this looks great to investors who, if only examining historical EPS, see a growth of 20% since last year! And next year the company can find another business to buy to continue manufacturing growth…
Seems like an easily-spotted con but these shenanigans seemed to have fooled a lot of Wall Street in the 1960’s. As an individual investor who glances at fundamentals in order to quickly screen hundreds of stocks, I probably would have been taken in as well.