The increase in Earnings Per Share (EPS) is not always synonymous with value creation because it is an accounting and arithmetic  metric that can be manipulated by financial engineering or short-term decisions, to the detriment of the real economic health of the company in the long term.

Here are the main reasons:

1. The illusion of financial engineering (Share Buybacks)

A company can mechanically increase its EPS without improving its operational performance, simply by reducing the number of shares outstanding (the denominator of the ratio) via  share buyback programs.

• The mechanism: The company uses its cash or takes on debt to buy back its own securities. Profit is  marginally reduced and divided by a lower number of shares, which drives up the net income.
• The destructive example (Boeing): The example of Boeing is striking. The company spent about $50 billion to buy back 400 million shares to boost shareholder returns and net income. However, this strategy deprived the company of resources for industrial investment and R&D (the 737 MAX), leading to human disasters, loss of technical credibility and massive long-term value destruction.
• Conclusion: Replacing productive investment with share buybacks increases immediate EPS but may sacrifice the future.

2. The trap of short-termism (underinvestment)

Executives are often tempted to sacrifice value-creating projects (with positive Net Present Value) to meet the EPS targets promised to analysts in the short term.

• The NBER Survey: A survey (Graham, Campbell, Rajgopal, 2005) reveals that more than half of CFOs are willing to reject a profitable investment (positive NPV) if it leads to missing the target for net earnings per share in the short term.
• Reduction of “investment” costs: To increase the net result (and therefore the net income), a company can cut expenses that are accounted for as expenses but which are in fact intangible investments: R&D, training, marketing, maintenance.
  • Kraft Heinz example: Drastic cost cuts (managed by 3G Capital) initially boosted margins, but ended up destroying the value of the brands and the company in the long run.
  • Spirit Aerosystems example: Cost pressures imposed on subcontractors to improve Boeing’s bottom line ended up degrading quality and safety, destroying value.

3. Ignorance of risk and the cost of capital

The EPS is a measure of profit, not risk-adjusted profitability. Increasing the net income through leverage (debt) can actually destroy value if the risk increases disproportionately.

• Leverage: If the economic return (ROCE) is higher than the interest rate on the debt, taking on debt mechanically increases the return on equity (ROE) and the net income.
• The cost of risk: However, increasing debt increases financial risk. Shareholders are then demanding higher profitability (increase in the cost of equity via Beta). If this increase in the cost of capital is not compensated, the value of the company (sum of discounted flows) may fall even if the net income increases.
• Inflation and rates: In times of inflation, nominal earnings (and net income) may rise, but if the cost of capital rises faster (rising interest rates), the real value of future flows decreases.

4. Distinction between Accounting Profit and Economic Profit

Real value creation is generated by the Economic Profit (EVA), which deducts the cost of all capital (including equity) from the operating result, which RNPA does not do.

• Net income is based on net accounting income.
• The EP (or EVA) (source of the MVA – Market Value Added) is based on the ability to generate a return above the weighted average cost of capital (WACC).
• A company can have a positive and growing EPS while having a negative EVA (if it invests heavily in projects whose profitability is lower than the cost of capital required by shareholders).

In summary, the net income measures a share of the accounting pie divided by the number of shares, while value creation measures the actual enlargement of the economic pie. Focusing solely on net income can lead to management decisions (underinvestment, excessive share buybacks, lower quality) that increase the numbers today but ruin the company tomorrow.