Company earnings drive share prices over the longer term. More specifically, earnings per share, or EPS, does. It’s the great attractor that ultimately pulls prices along.
You won’t find a single example of a company, ever, that has compounded its stock price over decades without also compounding EPS. It just doesn’t happen. That’s why EPS should sit at the centre of any analysis.
Sure, sentiment and narrative dominate in the short term. They remain highly influential in the medium term too. But if you want any hope of compounding wealth over decades, you need to be sure the underlying business can keep producing more profit for every share on issue.
It’s a lot like gravity, the weakest of the fundamental forces. At the subatomic scale it barely matters. But at the scale of galaxies, it’s the only thing that does.
What makes it tricky is that EPS can throw all kinds of curveballs in the near term. It can look good, but for the wrong reasons. Frustratingly, it can also look bad, but for good reasons. Some of your more mercenary CEOs know this well and have a few tools in their belt to help create the illusion of growth.
The classic example is a company that buys back shares without much regard for valuation. You don’t need a PhD in maths to see that reducing the denominator makes each share’s earnings look bigger. But when shares are trading well above any reasonable estimate of fair value, this kind of engineering is little more than financial cosmetics. It represents an overt misallocation of capital, delivering a return below the cost of capital and, in time, eroding the company’s ability to reinvest and grow.
Leverage is another culprit. Borrowing can certainly lift earnings, but it also magnifies fragility. Like investing with a margin loan, the upside looks bigger, but so does the downside. When debt is excessive, even a modest shock can threaten survival. Trade-offs are part of finance, as they are in life, but the dangers of leverage are among the easiest to ignore, especially when times are good.
The next thing to watch is cost cutting. Like leverage and buybacks, it isn’t automatically bad. At times, prudence demands it, and done well it can make a business leaner and more resilient. But it’s also one of the quickest ways to lift margins and therefore profits, at least in the short run. The problem is that the damage from overreach often takes time to show up. By then, the CEO may have already hit their KPIs, pocketed a bonus, and moved on.
This is also why investors shouldn’t reflexively panic when EPS falls. If profits per share dip because a company is laying foundations for the next stage of growth, that’s usually a positive. But when EPS rises only because R&D, marketing, or essential operational resources have been cut to the bone — rather than through genuine revenue growth — the reckoning eventually comes due. It’s the corporate equivalent of burning the furniture to heat the house.
And then there are the softer tricks; the adjustments and accounting sleights of hand that are technically allowed but can leave investors with a distorted picture. Recognising revenue a little early, capitalising costs that should have been expensed, presenting “underlying” earnings that quietly sweep aside the messy parts of reality. For a while, the optics can be convincing. But eventually, cash flow calls the bluff.
As they say: profit is vanity, cash flow is sanity.
The challenge for investors is not to dismiss EPS, but to interrogate it. The simplest test is whether earnings growth is matched by operating cash flow. Genuine EPS growth almost always shows up in the cash generated by day-to-day operations, while mirages tend to evaporate once you follow the money.
Returns on invested capital provide another important clue. If EPS is climbing but the business is generating no more on each dollar of capital employed, something is amiss and the growth is likely cosmetic rather than economic. True value creation requires reinvesting profit at attractive rates, not simply inflating the earnings figure through financial engineering.
The balance sheet also tells its own story. Rising EPS alongside a stable and healthy financial position is reassuring. Rising EPS that coincides with mounting leverage, swelling receivables or payables, shrinking inventories, or strained liquidity isn’t a smoking gun on its own, but it can be an important warning sign that the headline number is masking underlying weakness.
Even the notes to the accounts, so often skipped, are full of signals. It’s good practice not to take line items in the financial statements at face value.
Over the long term, reckless buybacks eventually get found out, excessive leverage meets a downturn, and cost cuts show up in weaker sales. And accounting tricks are hard to maintain. Time eventually separates the genuine from the illusory.
But in the here and now, these tactics can be highly effective. Sometimes they’re even well intentioned. The hard truth is, there’s no single formula that cleanly separates signal from noise. Investing never comes with perfect clarity.
What you can do is build a set of habits and heuristics that tilt the odds in your favour. Ask where the earnings are really coming from. Check whether the cash supports the story. Consider whether the balance sheet can carry the load. If you do, you’ll be less likely to fall for the obvious traps and more likely to back the businesses that are compounding for the right reasons.
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