The expected future growth in earnings per share (“EPS”) is an incredibly important factor in identifying an under-valued stock.
The impact of earnings growth is exponential. A company that grows earnings at 5% will be earning (1.0510 = 1.63) 63% more in ten years. But if the company grows earnings at 10% then it will be earning (1.1010 = 2.59) 159% more in ten years. Notice that when the annual growth doubled, the total growth in earnings in ten years grew by (159%/63%) 2.5 times. More dramatically if a company can grow earnings at 15% annually then it will be earning 304% more in ten years. In this case the growth tripled but the earnings in ten years more than triples to 4.8 times due to compounding.
Over 20 and 30 year periods the impact of a small increase in return is staggering. Five percent earnings growth compounded over 30 years results in earnings growing by a factor of 4.32 times or 332%. But 10% earnings growth compounded for 30 years results in earnings growing by a factor of 17.45 or 1,645%. In this case doubling the growth caused the earnings to grow by about 4 times.
Over the long run, the price of a stock will generally go up in lock step with its earnings (assuming the P/E ratio is constant). Therefore stocks with higher earnings growth should offer the highest capital gains. And doubling the growth more than doubles the capital gain, due to the compounding effect.
It’s worth remembering that some growth measures do not have such a direct impact on the price of a stock.
Growth in the industry, though often touted as a panacea, may be of absolutely no help. If an industry is very competitive and offers few barrier to entry of new competitors then growth in the industry sales may lead to no increase in earnings per share of the existing competitors.
Growth in earnings may not translate into any increase in per share earnings if the company is issuing new shares. This is why we need to focus on earnings per share.
Growth in revenues does not necessarily translate into growth in earnings per share. Some companies such as Air Canada have stubbornly chased after growth in market share while all but ignoring the goal of growing earnings
per share.
Given the importance of identifying companies that will grow earnings per share at high rate, we then need to consider how to identify which companies will achieve high growth rates.
One obvious way to identify high earnings per share growth companies is to find companies that have demonstrated such growth over the past 5 to 10 years. We can’t assume the past will always reflect the future, but logically stocks that have grown earnings per share strongly in the past are a good bet to continue to do so.
Another way is to seek out companies with a high return on equity. The direct relationship between return on equity and growth is explained in my article on that subject.
Investors have to be careful not to buy stocks where all of the expected growth and more has already been priced-in to the stock. See my detailed article on this subject.
September 14, 2002
Shawn Allen, Editor