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Bloopers & Blunders:
Earnings vs. Value - FASB Proposition and EPS

Background. The Financial Accounting Standards Board (FASB), the chief rule maker for accounting, has proposed a rule that would "reduce the dilutive effect of stock options, warrants and convertible securities" on earnings-per-share (EPS). In effect it would decrease the number of shares outstanding, thus increasing a company’s EPS.

Question

In trying to explain the effect of the new rule on stock prices, the Journal quoted an accounting specialist as saying that '[t]he lower P/E will encourage technical market analysts to conclude that the stock should be trading at higher levels.'

Answer

Obviously if EPS increases, then the price-to-EPS (P/E) ratio would go down. But then, the analyst claims that this would tend to increase stock prices!

The analyst must still think that investors are fooled by pure accounting manipulations, despite a large body of empirical evidence to the contrary. An increase in stock prices is typically driven by events that stimulate corporate value creation. Where is the additional value coming from in this scenario?

A change in the language of counting your beans from English to, say, French should have no impact on how many beans you actually have. Only when you somehow obtain more beans would the count change. In the EPS scenario, all you are doing is counting how many shares are actually outstanding; you cannot fool the market about the true number. ‘The change is to get the U.S. more in line with international harmonization of accounting standards so that major countries can have similar accounting’ to facilitate international comparisons among companies, another analyst explained.

By Alex Tajirian