Modeling Managers As EPS Maximizers

Abstract

Textbook corporate-finance theory assumes that managers maximize the NPV (net present value) of expected future equity payouts. However, in practice, the people running large public companies often seem more concerned with increasing EPS (earnings per share). Perhaps this is a mistake. Or maybe EPS growth is a good second-best proxy for value creation. Whatever the reason, we show that the simplest possible EPS-maximizing model predicts a number of important financing decisions, such as optimal leverage, new issuance, share repurchases, and cash holdings. The principle of EPS maximization leads to a novel micro foundation for distinguishing between value and growth stocks. There are two different routes to maximizing EPS, depending on whether a firm’s earnings yield is above the riskfree rate (value stocks) or below it (growth stocks). We examine the data and find strong empirical support for our model’s key predictions.

Zahi Ben-David's webpage.