Having reached the midpoint of reporting season, we examine the relationship between medium-term changes in market cap and EPS.
It’s earnings stupid
A regular question we hear from managers is how we can increase the share price. While it sounds obvious, the number one driver of a company’s valuation (and consequently its share price) is its earnings. As discussed in January with Matt Griffen from Maple-Brown Abbott (see ‘2025 Outlook - Matt Griffin - Maple-Brown Abbott’), over the medium and long term, share prices will follow earnings, especially for small caps.
Many factors, but one stands out
To test this theory, we looked at the EPS and market cap growth of Australian small caps companies (with market caps less than $5 billion in FY21) between FY19 to FY24 and FY21 to FY24. We didn’t include FY20 as a base year in order to avoid the worst effects of COVID. We focused on small caps as they tend to have the strongest correlation with earnings.
To avoid loss-making companies and extreme outliers, we chose a subset of companies outside the ASX100 index. The criteria we used was:
• Market cap (FY21): less than $5b
• EPS (FY21): greater than $0
• EPS growth: less than +500%
• EPS decline: no more than -100%
• Sectors: excluded metals & mining and energy
• Operating companies – excludes all funds and EFTs
A total of 265 companies fit this criteria.
As shown in Table 1, we found a covariance of 0.31 between the market cap and EPS growth between FY19 and FY24, and a correlation of 0.40. We found a similar relationship between EPS and market cap changes from FY21 to FY24 with a covariance of 0.40 and a correlation of 0.44.
Table 2 summarises the results of the 265 companies we examined. 182 (71%) of the companies behaved according to the expectation (positive EPS growth with positive market cap growth or EPS decline with market cap decline). While only 78 (29%) companies defied the expectation (positive EPS growth with market cap decline or EPS decline with market cap growth).
Figure 1 below shows the market cap growth between FY21 and FY24 against the earnings per share (EPS) change over the same period for the universe of stocks we examined.
As is evident, there is a concentration of companies in the quadrants supporting the assertion (top right and bottom left) with a trendline showing the correlation between EPS and market value.
While this relationship alone doesn’t necessarily help investors find outperforming companies, it does show there is some rationality within the market and that over the medium and long term, a company’s earnings are a key driver of its market value.
In the analysis above, we excluded companies where EPS declined more than -100%. When this occurred, we found that the correlation between market cap and EPS was less pronounced (correlation of 0.23) despite the covariance being similar (0.40). As shown in Figure 2, the trend line has a far more moderate incline, so while a contraction of the market cap is expected following EPS turning negative, the magnitude of the contraction is not highly correlated with the magnitude of the decline in EPS.
Of the 241 companies that match our criteria with EPS declines, five saw EPS drop by -100%, while 97 saw EPS turn negative. Overall, 86% (207) of companies with declining EPS also saw their market caps decline.
