Why 8% Growth In Earnings Per Share Is (Often) Only Barely Acceptable
It has been well established that stock market investors require and expect at least an 8% (approximate) annual return on investment. Investors can currently earn just over 4% in long term bonds. It is often thought that investors expect an additional 4% return (approximately) to compensate for the risks in the stock market.
It is not so well known however, that a required 8% return is equivalent to requiring earnings per share to grow at a rate of 8% minus the dividend yield (if any).
How fast does a company that pays no dividend have to grow its earnings per share in order to provide an 8% return?
This question cannot be answered unless we first assume that the P/E ratio will remain unchanged. If the P/E ratio is expected to remain unchanged then the company needs to grow earnings per share at 8% annually to provide an 8% return to the investor. Similarly, if you expect a 10% return then the earnings per share must grow at 10% annually.
If you invest in a zero-dividend stock with a P/E of 15 and you don’t expect the P/E to change then your return must come entirely from the capital gain which is then riven entirely by the growth in earnings per share.
So, a zero-dividend company that expects to grow earnings per share at 8% annually is barely acceptable. The investor requires an expected 8% and this is what the company offers. The company’s shares are not a bargain unless one could expect the P/E to rise or that the earnings will in fact grow faster than 8% annually.
How Do Dividends Affect the Analysis?
The expected return on a dividend paying company where the P/E ratio is not expected to change is approximately equal to its expected growth in earnings per share plus the dividend yield. A company that pays a 3% dividend yield only needs to grow earnings at 5% to provide an 8% return.
What are the Implications?
High expected returns above 8% will require earnings per share growth in excess of 8% (or 8% less the dividend yield) or an expectation of an increase in the P/E ratio.
Often stocks are trading at relatively high P/E ratios and it then should be assumed that the P/E ratio will revert to a more sustainable (and lower) level in future. In this case the earnings growth will have to be even higher than 8% to offset the decline in the P/E.
High returns may therefore be difficult to find given that they require significant growth.
The overall economy only tends to grow at about 4% to 5% including inflation. A company that earns 8% return on equity can return 8% to the investor on a sustainable basis. This can be explained by the fact that an average company may dividend out 40% of earnings so that an 8% ROE turns into an 8*(1-0.40) = 4.8% growth rate.
Management that grows earnings at 8% minus the dividend yield are providing only an 8% return (assuming the P/E will not change) which is barely acceptable. Despite this, stock option plans usually lavishly reward such merely average and merely acceptable performance.
A stock with a P/E of 6 and no dividend is no bargain at all if the earnings are not expected to grow and the P/E is not expected to rise. In fact, if it pays no dividends and it cannot grow earnings, even in the long term, it is theoretically worthless.
What is the Investment Action?
Avoid companies that cannot offer an expected earnings growth plus dividend yield of at least 8%. 8% is a barely acceptable level. And this assumes that the P/E will not drop. Demand even higher growth if the P/E is even moderately high (> 12).
In general avoid companies with a P/E above 20, they are pricing in too much assumed growth.
Seek companies with a high return on equity since a higher return on equity drives a higher growth in earnings per share. Be wary of companies that continually issue more shares, it becomes harder for them to grow earnings per share if the number of shares is increased.
September 21, 2002
Shawn Allen