Author: Michael Carter, Reseacher - Finstock, Inc.
Introduction
For decades, earnings per share (EPS) has occupied a central role in equity valuation, often viewed by analysts and investors alike as the definitive measure of a company’s profitability and performance. The EPS–P/E multiple framework became the standard valuation tool taught in business schools and practiced across Wall Street. Yet, in 1974, Joel M. Stern’s article “Earnings per Share Don’t Count” shook the foundations of this orthodoxy.
In what is now regarded as a seminal piece in financial thought, Stern argued that EPS was a flawed and often misleading indicator, and proposed free cash flow (FCF) as a superior alternative. His arguments not only challenged existing assumptions but also catalyzed a broader reevaluation of valuation methodologies. This article revisits Stern’s ideas, examines their reception, analyzes the EPS vs. FCF debate through empirical and theoretical lenses, and considers the long-term legacy of his work on modern valuation practices.
Stern’s Radical Proposition: The Flaws of EPS
Stern’s central thesis was that EPS, though intuitive and easy to calculate, often fails to capture the true economic reality of a business. Through logical examples, he illustrated how two companies with identical EPS could have vastly different valuations due to differences in capital requirements. One company may sustain growth internally, while the other must raise external capital—leading to either earnings dilution (if funded by equity) or increased risk (if funded by debt).
Stern’s key contribution was the concept of free cash flow (FCF)—defined as net operating profit after taxes minus the capital expenditures required to maintain or grow the business. By focusing on the actual cash left over for shareholders, FCF addressed what EPS ignored: the opportunity cost of capital, risk, and investment efficiency.
The Six-Variable Model
To formalize his theory, Stern proposed a six-variable model that emphasized FCF drivers:
Net operating profit after taxes (NOPAT)
New capital investment
Expected return on that capital
Duration of the return
Business risk
Tax benefits of debt
This comprehensive model shifted focus from accounting profits to economic value creation. It not only provided a richer basis for valuation but also introduced the idea that valuation is inherently forward-looking and sensitive to both financial strategy and risk perception.
Reception and Immediate Influence
Despite its radical tone, Stern’s article quickly gained attention in both academic and practitioner circles. The Harvard Business School’s student performance lampooned EPS obsession, and authors like Alfred Rappaport cited Stern in challenging EPS as a basis for evaluating acquisitions. The shift Stern proposed fed directly into the development of Value-Based Management (VBM), a philosophy that aligns corporate decision-making with shareholder value.
Stern’s ideas also influenced the creation of new performance measures such as Economic Value Added (EVA), later popularized by the consulting firm he co-founded, Stern Stewart & Co. EVA adjusts accounting earnings to better reflect economic reality, further distancing modern valuation practices from EPS.
Yet, the transition wasn’t immediate. Analysts, asset managers, and the broader investing public retained their reliance on EPS for years, largely due to its familiarity, regulatory backing (via GAAP), and presence in financial media. However, beneath the surface, FCF and value-based models steadily gained ground.
The EPS vs. FCF Debate: Evidence and Interpretation
Empirical Support for FCF
Proponents of FCF often point to its superior predictive power for long-term stock performance. Research by Foerster, Tsagarelis, and Wang (2017) finds that direct cash flow measures outperform traditional accounting metrics in explaining stock returns, especially when adjusted for risk and nonrecurring items. This makes FCF particularly useful in assessing companies with complex capital structures or significant intangible investments.
The direct cash flow method, encouraged by both IFRS and US GAAP, clusters cash flows into operating, investing, and financing activities—improving transparency and isolating true value-creating operations. Firms ranked highest in direct FCF metrics have consistently outperformed those in the lowest decile by significant margins.
Caveats and Limits of FCF
However, FCF is not a panacea. Critics argue that cash flows can be highly volatile and sensitive to timing differences or management discretion. Additionally, not all industries or business models lend themselves easily to FCF analysis—for example, financial institutions or early-stage startups.
Studies by Liu, Nissim, and Thomas (2007) suggest that in certain cases—particularly when focusing on forecasts rather than reported numbers—EPS may correlate more strongly with stock prices than cash flow. Furthermore, EPS has the advantage of reflecting non-cash obligations like pension liabilities or share-based compensation that cash flow might ignore.
Beyond the Numbers: Psychological and Practical Barriers
Another reason EPS retains its dominance is behavioral. Investors and analysts are prone to cognitive shortcuts, and EPS is easily digestible and comparable across companies and time. Corporate managers, aware of this bias, often manage earnings to meet consensus EPS forecasts—a phenomenon that has led to “earnings smoothing” and quarterly guidance strategies.
Stern himself criticized this behavior, arguing that it incentivized short-termism and distorted long-term value creation. The use of FCF, in contrast, is harder to manipulate and encourages a more strategic view of performance.
A Changing Landscape: The Rise of Intangibles
One of the most compelling validations of Stern’s critique comes from the modern corporate landscape. According to Clarivate (2023), intangible assets account for over 80% of S&P 500 market capitalization—up from just 12% four decades ago. Companies now derive value from intellectual property, brand equity, and data—assets poorly captured by GAAP accounting.
These companies often report low or negative EPS due to expensing R&D, despite having strong economic fundamentals. In such cases, traditional P/E multiples become meaningless, necessitating valuation based on sales, EBITDA, or discounted FCF.
Valuation platforms like Credit Suisse HOLT and Valens Research now use adjusted cash flow models or Uniform Adjusted Financial Reporting Standards (UAFRS) to bridge the gap between accounting limitations and market reality.
Educational Influence and Institutional Adoption
The CFA Institute has incorporated FCF analysis into its core curriculum, highlighting its centrality in modern valuation. As Pinto et al. (2024) noted, most analysts use multiple valuation methods, but free cash flow is now in near-universal use, especially for DCF modeling.
This evolution reflects a broader pedagogical shift. Business schools, once reliant on accounting-centric tools, now emphasize economic drivers of value and encourage students to examine capital intensity, reinvestment needs, and risk-adjusted returns.
Conclusion: A Lasting Legacy of Critical Thinking
Joel Stern’s 1974 article did more than critique EPS; it challenged analysts to think more deeply about what creates value. His introduction of FCF paved the way for more dynamic, flexible, and forward-looking valuation practices. While EPS still has a role to play, especially in communication and short-term comparisons, it is no longer the only—or even the best—tool in the analyst’s kit.
In an era defined by digital transformation, intangible assets, and financial complexity, Stern’s message is more relevant than ever: valuation must reflect reality, not just accounting.
By daring to question orthodoxy, Stern empowered a generation of analysts to seek out better answers—and 50 years later, the profession continues to benefit from that courage.
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