# How Negative Growth Calculations Can Actually Mislead Investors

Updated – 12/14/23

Earnings growth is the life blood of Wall Street. You see this with the obsession of earnings season and analyst projections. But these calculations can trip up beginner investors, especially when growth is negative.

The calculation for negative growth can be confusing. Sometimes it’s straightforward, sometimes not. So it’s extremely important to know the common mistakes for negative growth calculations.

In general, long-term stock pickers should buy stocks that are growing earnings over the long term. A company might trip up with a year of negative growth, but this doesn’t mean it’s always bad for its long term outlook. You have to know how to deal with growth rates when they go from negative to positive, and vice versa.

I know that the formula for negative growth can be misleading. I know it for an absolute fact because I’ve received several emails asking for help with it.

This blog post will outline those and show where the confusions in growth calculations with negative earnings can appear.

## How to Calculate Earnings Growth

Before we can differentiate between negative growth and positive growth, we need to know how to calculate growth in its simplest form. Here’s the most basic way I can think of to explain this.

Say you have \$100. It grows to \$125. So it’s now \$25 more. \$25 is 25% of 100, so you have 25% growth.

The formula for growth (rate) is:

(Present value – Initial value) / Initial value

Here’s the problem. When your initial, or starting point, is negative… the calculations are off. Say a company had -\$25 earnings initially. After a year it’s now at \$50. Using the formula you get:

(50 – -25) / -25
(50 + 25) / -25
= -3
= -300%

That’s not right. Earnings went up, not down. But the formula says down, it thinks you have a negative growth situation. This is just the way the math goes. The growth formula works, but only when using a positive starting point.

Keep this in mind. If you are using an algorithm or formulas to automatically analyze stocks, there can be an error in the growth rates when negative numbers are involved.

## How Positive and Negative Growth Gets Confusing

After sharing the earnings example above in an email to subscribers, I received another one in reply. This subscriber mentions algebra and takes a simplistic approach to the growth calculation. On the surface, it makes a lot of sense. But I wanted to include it in this post to flesh out the growth calculations further.

When seeing years where earnings are negative, it can be tempting to flip one of the negative years to positive to attempt to find the correct value.

In algebraic terms, this seems to make sense. However, the whole point behind calculating the growth of earnings from year to year is to try and highlight which companies are doing better at expanding their business (and profits) than others.

Where the growth formula can break down is when you consider the intent behind the calculation and what part of it is really important to us as investors.

It’s not fair to a company that goes from \$100 to \$400 to say they went +300% but also tell the -\$25 to \$50 they also went up +300%. That’s REWARDING the company that in reality did worse, or PUNISHING the one with real growth.

Say the company started at -\$1,000 and went to \$50. Using the return formula gives us -105%. So the same ending \$50, but the company starting at -\$25 had higher/the same growth (+300%) than the company starting at \$25 (100%) and the company starting at -\$1,000 (105%)…

In reality, the company that started at -1,000% dug itself out of a bigger hole and had a better “improvement” than the -\$25 company. But that’s not real growth. It’s actually PUNISHING the stocks that did have real growth i.e. \$25 to \$50.

One last example. Say a stock had negative earnings of -\$1 that then went to \$50. That’s 4900% growth. That’s not quite representative of the true growth story.

Bottom line: you can’t calculate growth from a negative earnings year because it’s unreliable. The math doesn’t check out, and the logic doesn’t check out. Definitely something more investors need to know.

## How Stock Pickers Can Handle Negative Earnings

Our reader had this to say after I explained the math behind negative earnings:

“Your right! Going from a “-” would not be real growth only an improvement in earnings.  As you said, going from a positive earnings value would be true growth.  I’m wondering then if negative earnings can even fit into the overall equation.  A company is just outright having a bad year or two with negative earnings, and actual growth doesn’t take place until earnings become positive.  I guess, if a company has a string of “-” EPS the investor will have  to decide how he wants to handle the shares.  Hold, and hope things turn around and the company once again is showing growth, or sell before the rest of the market realizes what’s going on.”

Ding, ding, ding! We have a winner. This guy gets it. And hopefully after reading this post, you do too. It’s very important to accurately identify when a company has negative growth or positive growth, and also equally important that your formulas are not rewarding companies who had major losses the year before.

After all of this, the next natural question is what to do specifically about a company when they get a year of negative earnings. Well, I’ve covered this in this blog post about a negative P/E ratio, and this podcast debate with my co-host Dave. Check them out.

## Andrew Sather

Andrew has always believed that average investors have so much potential to build wealth, through the power of patience, a long-term mindset, and compound interest.

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