By Jason Apollo Voss, CFA

Investors almost always have an opinion about the overall valuation level of financial markets. Differences in these opinions, of course, lead to different preferences for bids and asks — and hence, prices.

Markets are not necessarily rational; it’s just that the tug of war among investors disagreeing on valuations is more likely to lead to accurate pricing than not. One extreme view of markets is that prices are objectively determined, and an informationally efficient evaluation of the performance of businesses.

But what if these different opinions about the overall price of financial markets are based on a measure — the price-earnings ratio — that's susceptible to the subjective manipulation of businesses themselves, via financial engineering?

This leads me to ask the question: Are reported numbers really earnings, or just financial engineering?

Specifically, I’m talking about the ability of companies to control their total shares outstanding through issuance of more shares of stock and options and more importantly, via share buybacks. In short, chief financial officers have an easy ability to alter their firms’ shares outstanding. Which, to some extent, makes their earnings per share (EPS) a less than objective measure of performance.

It comes down to simple math. When you decrease the shares outstanding through a buyback, you magically manufacture higher EPS. CFOs can also probably create a higher valuation, assuming the P/E ratio increases or remains the same.

Therefore, investors need a more “financial engineering-free” P/E number to get a truer sense of valuation. This calculation turns out to be straightforward and is easy to calculate, as follows:

In other words, market capitalization divided by net income is our alternative measure. Yes, shares outstanding remains in the numerator. But it is completely absent in the denominator, which is where financial engineering has its biggest effect in manipulating the appearance of business performance.

Our P/E-Alt Measure in Action, Part I

What is the effect of financial engineering on a major index like the S&P 500? Here is what P/EAlt looks like for the S&P 500 since 2010. Row 1 is the traditional P/E measure, and Row 4 is P/E-Alt.

As you can see, for every year except 2010, the alternative P/E is much higher, meaning that the valuation is much richer for these businesses than initially appears to be the case. In other words, via financial engineering, companies are managing their EPS through share buybacks.

Typically this results in a pat on the back from investors, because companies make their earnings numbers. Firms also look more attractive as stocks because, on average, they appear to be less expensive.

On average, the difference in the two measures of P/E is 9.4 percent.  If we omit 2020’s outlier value of 39.8 percent, the average is still 6.4 percent. This effect is considerable and it helps to highlight two important things:

  1. The amount of manipulation of earnings per share. Said another way, business performance is consistently 6.4 percent worse than it appears.
  2. Just how rich valuations are for the S&P 500, because investors are willing to pay more for these companies than may be warranted by their actual profit performance.

At least we now have a more objective, more financial engineering-free measure of valuations.

Our P/E-Alt Measure in Action, Part II

But wait,  there’s more! Because companies can fudge their shares outstanding rather effortlessly, it also means that investors should not only look at the change in growth of EPS, but also at the change in growth of net income.

The difference between these two figures is also another way of examining the effect of financial engineering on a business.

Let’s use the same two companies I used in my last guest article for Calcbench where I compared Google ($GOOG) and Apple ($AAPL) to one another:

As you can see, Google’s net income has grown faster than its earnings per share: 16.8 percent compound annual growth rate in net income versus 16.1 percent for EPS. This means that Google issued shares at a rate faster than net income. We can also conclude because net income growth exceeds EPS growth, minimal financial engineering is taking place. Additionally, it’s encouraging to see the two figures so close to each other (16.8 percent and 16.1 percent), from a “we are not trying to fool you” standpoint.

In contrast, Apple’s EPS has a compound annual growth rate of 19.7 percent while its net income has a compound annual growth rate of 15.1 percent. In other words, its EPS has grown 30.4 percent faster than its net income. We may safely conclude that Apple is engaged in a much higher level of financial engineering than Google, based on the figures above.


When evaluating a company’s performance, it’s tempting to use earnings per share, or operating income per share, or EBITDA per share, and so on. But because companies have high levels of flexibility in controlling their total shares outstanding, investors need measures of performance that excise the effects of financial engineering as much as possible. In turn, this means we get a truer sense of performance and ultimately, valuation. Yes!

Editor’s note: If you want to conduct your own analysis along the lines of what Voss outlines here, Calcbench has created an Excel template you can download and use at home.

One detail: Voss accounts for stock splits manually, which are important in his examples. Our template allows the user to enter a stock split factor and have the calculation work for their case. If there is no split, the factor defaults to 1, making the template work.

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