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 how they can be improved, and which types tend to receive more focus… depending on the company itself. 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)
From a conceptual standpoint, earnings per share makes a lot of sense 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, because 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.
Since each share of a publicly traded company represents a part-ownership stake in a business, 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; companies choose to retain part of a company’s profits in either to reinvest in future company growth, strength 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, and particularly in the dividend growth rate per share.
2—Dividend Per Share Growth Rate
The dividend per share growth rate is more important than EPS growth to some investors 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, because stock prices don’t 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, which is where the Price to Earnings (P/E) ratio comes into play.
The P/E ratio of a stock can fluctuate throughout time for a stock, and 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, this means that the prices isn’t always directly following earnings, which is where the disconnect from EPS growth and share price growth can diverge.
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 in the dividend paid out to you 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.
Sometimes investors consider dividend paying stocks to be matured and having little in the way of future growth prospects.
This couldn’t be further from the truth.
There have been countless examples of companies who have compounded their capital at extremely high rates while still paying a dividend, leading to huge stock returns from the combination of high company growth rates and a high dividend growth rate.
The best growing companies aren’t always the youngest or smallest companies, although that seems to be the idea around those kinds of stocks and why the focuses on company growth rates can differ.
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 the more traditional EPS growth to evaluate these companies is because many of these companies are plowing all of their revenues back into the business, leaving little left for profits at the end of the year.
This is also known as “investment through the income statement”, and it occurs when a company spends aggressively on income statement items such as marketing (under SG&A), research & development, or other essential 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 that many high growth companies decide to abandon profitability in order to achieve high company growth rates 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 in order to capture a large share of the streaming market, with the idea that once they had become an established player, the company could scale back marketing spending and/or raise prices and have great profits over 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 which sacrificed short term profitability. But, over the past year, that SG&A spending growth has slowed down while revenues have continued to climb—showcasing 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 through relatively low fixed costs and their current base of content and customers.
Why Revenue Growth is Preferred by Some Investors
Since a few of these 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 they naturally won’t post high profits or profits (EPS) growth.
So, a different measure of the company’s growth rate is needed, which is where revenue (or “top line”) growth comes in.
Some people might think of headcount (number of employees) growth as a staple for company size, but this is not generally helpful across industries since payrates can vary so much between them. Revenue growth is a constant no matter what business you are in, and so measuring its growth between companies and industries can give an apples-to-apples comparison in true company size.
High rates of revenue growth mean that either a company is picking up market share, the market itself is growing very quickly, and/or the company is able to raise its prices or sell through a higher price mix.
These are all things that can lead to higher growth for the company in the future—as EPS growth might become easier to attain with a dominant market share, or the ability to raise prices indicates that the economies of scale are already paying off and huge growth in profitability is down the pike.
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 à High Earnings Per Share Growth à 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 on what is achievable for a company depending on their industry, market conditions, their competitive advantages, and a myriad of other factors.
4—Free Cash Flow Per Share Growth
This last type of company growth rate is much less publicized on Wall Street but is undoubtedly just as (if not more) important than all of them.
Many of the valuation models which are used on publicly traded stocks today rely on calculating Free Cash Flow (FCF) per Share, 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 of the actual cash flows available to shareholders at a set time, because the accounting for earnings is a little nuanced.
Earnings don’t represent the true cash situation of a business because the accounting is adjusted for tax purposes and to present a better picture of the financial results of the operations of a business from year to year.
Large capital outlays as long term investments for future company growth might affect short term cash flows but don’t necessarily indicate poor operating results; it’s for this reason and others that depreciation was invented and 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 are likely to receive.
Some businesses might have great earnings power, but also require continuous capital outlays in order to continue long term operations, which can greatly limit the actual cash flow available to be distributed back to shareholders now and in the future.
Analysts also use free cash flow as a signal for how a company is likely to perform in the future, based on how management expects future demand and how much they are investing in working capital and capital expenditures.
FCF/ share is preferred by many great investors such as Warren Buffett (who has his own version he calls Owner’s Earnings), who can see the attractiveness of lower capital intensive businesses in producing future shareholder return.
To recap, you can estimate a company’s growth rate through a variety of factors, with the following four as 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 being 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, and Singleton was a leading example of doing exactly that.
That said, you probably can’t get decent long term returns without growth either.
So 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.