Investors demand growth from companies. Wall Street loves growth. But how is company growth defined exactly?
In this post we’ll examine 4 separate types of company growth rates, and when they are used depending on the type of company. First, let’s start with the bottom line, or Earnings Per Share.
1—Earnings Per Share Growth
Earnings per share (EPS) is basically the lifeblood of Wall Street. Maybe legendary fund manager Peter Lynch from Fidelity’s Magellan summed it up best:
“Behind all the smoke and noise on the market’s surface, it’s important to remember that companies — small, medium, and large — make up the market’s backbone. And corporate earnings drive stock prices.”
The formula for EPS is the following:
EPS = Earnings / Shares Outstanding
EPS is an easy concept because it refers to the earnings available to each shareholder (per share).
You can think of earnings as profits, also called net income. They are all one and the same.
Of course, profits are what’s left over after a company brings in revenue and pays all of its expenses.
This is important to a business owner. An owner buys, operates, and/or invests in a business in order to receive a share (part or whole) of all of a company’s current and future profits.
Each share of a publicly traded company represents a part-ownership stake in a business. So, it’s these profits that a publicly traded company creates (earnings) that are owned by the collective group of shareholders. Shareholders have a claim to the current and future earnings of the company.
Shareholders don’t always receive the earnings earned by these businesses, however. All companies can choose to retain part of a company’s profits either to reinvest in future company growth, strengthen the company’s balance sheet, or buyback shares.
The earnings that are directly distributed to shareholders are called a dividend. These are transfer payments—from the company’s earnings to the owners of the business, with a certain dollar (or cent!) amount paid out on a per-share basis.
To the income-focused investor, those dividends per share are more of a primary focus than any other of these types of company growth rate. We will talk about this next.
2—Dividend Per Share Growth Rate
The dividend per share growth rate is preferred by some because it represents “real,” tangible returns to shareholders.
Because while a company might grow its EPS at a great rate, this doesn’t always translate to high stock returns. That’s because stock prices don’t necessarily trade in lockstep with their EPS on a 1-to-1 basis.
Some stock prices are cheaper, and some more expensive, compared to their EPS and EPS growth rates. That’s where a popular ratio like the Price to Earnings (P/E) ratio comes into play.
The P/E ratio of a stock can fluctuate throughout time for a stock. It can also depend on things like the industry a company plays in or their perceived competitive strength in that industry.
Since the P/E fluctuates, prices aren’t always directly following earnings, which is where the disconnect from EPS and share price growth happens.
But, dividends per share growth rates don’t diverge.
If a company decides to grow their dividend by 10% in the next quarter, you will receive a 10% increase regardless of what happens with the stock price.
Dividend yields fluctuate with the stock price, but the actual dividends per share paid does not.
So, once you’ve locked in a stock with ownership of shares, you will receive the dividend per share announced by the company each quarter. And, these tend to grow consistently over time especially with well-run businesses.
3—Revenue growth
Revenue growth is one of those metrics that is widely used with younger and more “high growth” type of companies.
The logic behind using revenue growth instead of EPS growth is that many of these companies are aggressively spending for growth. This naturally leaves little left for profits at the end of the year.
This is also known as “investment through the income statement.” It occurs when a company spends on income statement items such as marketing (SG&A), research & development, or other operating expenses.
To be clear, companies can both plow all of their earnings back into a business and still report EPS growth.
How that capital is invested will determine whether a company shows either revenue growth or profit growth.
Quick Primer on High Growth Companies
The reason to abandon profitability for high growth is because some markets bring advantages to the biggest players. This is also called economies of scale.
Take Netflix as an example.
For many years, Netflix posted very little in profits because they were aggressively spending to capture a large share of the streaming market. The goal was to first become an established option for consumers. Then, the company could scale back marketing spend and/or raise prices and have great profits in the future.
Over the past 3 years, that’s exactly what has happened, where previously, marketing spend (SG&A) rose aggressively alongside their great revenue growth. This sacrificed short term profitability. But, over the past year, SG&A growth has slowed down while revenues have continued to climb. It really showcases the positive effects of Netflix’s large market share in streaming and their customers’ stickiness to their subscriptions.
Now the company is at a big enough size where they can share some of their operating expenses while still maintaining high market share. Due to the way their platform is distributed, the company has relatively low fixed costs on their current base of content and customers.
Why Revenue Growth is Preferred by Some Investors
A few high growth companies tend to post extraordinary market returns over a very short time. Many investors are inevitably attracted to the promise of quick riches, and thus prioritize those metrics.
If a company’s strategy is to scale to a certain size in order to leverage future economies of scale, then it makes sense. The company naturally won’t post high profits or profits (EPS) growth.
That’s where revenue (or “top line”) growth comes in.
High rates of revenue growth can mean that a company is picking up market share. Or it could mean the market itself is growing very quickly. The company could also be displaying pricing power or selling a mix of higher price products.
These are all things that can lead to higher growth, in all 4 growth types, for the company in the future.
In the typical lifecycle for a very successful company, you’ll tend to have the following (with each step occurring first and then leading to the other):
High Revenue Growth >> High Earnings Per Share Growth >> High Dividend Growth
Of course, there’s technically nothing preventing a company from achieving all 3 at the same time, but those seem to be the exception more than the rule. It all depends. It depends on their industry, competition, and many other factors.
4—Free Cash Flow Per Share Growth
This last type of company growth rate is less popular but is undoubtedly just as (if not more) important as all of them.
Many of the valuation models which are used on Wall Street rely on calculating Free Cash Flow (FCF) per Share. That’s because better free cash flow tends to lead to better future earnings.
Though EPS is a decent proxy for the profits available for owners, free cash flow is a more accurate representation. FCF reports on the actual cash flows available to shareholders at a set time. Also, the accounting standards for earnings can be a little nuanced.
Earnings don’t represent the true cash situation of a business because the accounting is adjusted for tax and other purposes. In general, standardized accounting attempts to present a better picture of the financials.
Big, long term investments for future growth might affect short term cash flows, but these don’t necessarily indicate poor operating results. It’s for this reason (and others) that depreciation was invented. Depreciation provides one of the major dichotomies between earnings and free cash flow.
Free cash flow is considered a better measure than earnings by many investors and analysts because it represents how much cash flow investors could receive.
Some businesses might have great earnings power, yet consume large amounts of cash. They may require continuous capital outlays in order to continue long term operations. Outlays such as capital expenditures can greatly limit the actual cash flow available to be distributed back to shareholders.
FCF/share is preferred by many great investors such as Warren Buffett (who has his own version he calls Owner’s Earnings). Great investors recognize the attractiveness of companies that don’t need much capital to grow. These tend to produce great shareholder return.
Investor Takeaway
To recap, you can estimate a company’s growth rate through a variety of factors. These four are some of the more popular:
- Earnings Per Share Growth
- Dividend Per Share Growth
- Revenue Growth
- Free Cash Flow Per Share Growth
You might notice that the more you study financial statements, the more that metrics like these tend to work together. And so, it’s not always about deciding about the “best metric” to use but rather what each metric is trying to tell you.
I hope you’ve internalized that company growth rate can be subjective and doesn’t always lead to high shareholder return.
There are other factors which eventually contribute to the return you’ll get when investing in any company in the stock market. Growth is just one of the many.
While they might not be the most popular ideas, big company size and big company growth rates aren’t always the most optimal strategy for every business. These might not be the best strategies for shareholders either, even if they are better for company longevity or other company goals.
I’d encourage you to read about how companies can stay small and yet provide fabulous long term returns for shareholders. One great example of this was Henry Singleton and his stock buyback strategy.
You can greatly increase the shareholder value of a stock without growing the company itself all that much. Singleton was a leading example of doing exactly that.
That said, you probably can’t get decent long term returns without growth either.
Company growth rate metrics such as revenue growth and EPS/FCF growth can be very important, especially with a business in decline. A business in that dreary stage can only cover up bad performance through buybacks or expense cutting for so long, eventually destroying shareholder value and your returns.
Updated: 8/17/22
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