Earnings growth is the life blood of Wall Street. You see this with the obsession of earnings season and analyst projections and estimates. But these calculations can trip up beginner investors especially when growth is negative.
Half of the time the calculation for negative growth is straightforward, and the other half of the time it isn’t. So it’s extremely important to know the common mistakes for negative growth calculations.
After all, you want to be buying 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. I’ll also walk you through my answers to these great questions, to hopefully guide you through calculating earnings growth on your own.
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 this is: (present – initial) / initial.
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
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. No one really talks about it…
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 simply flip one of the negative years to positive in order to attempt to find the correct value.
In algebraic terms, this seems to make sense. However, the whole point behind calculating 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. I understand what I just said might be a little confusing, so let me share the exact email exchange I had with this subscriber. It’s bound to mislead some investors who don’t try and think it completely through– which can be a tragic mistake. The email:
The answer to your problem is 100% growth.
You have too think of it in terms of algebra. You need to multiply the -25 by negative 1 converting the -25 to a +25, and then subtract from 50 and divide by 25. The equation looks like this:
(50 – (-1(-25)) / 25.
Think of it this way.
-25 to 0 is 25, and 0 to 50 is another 25. Hence, you arrive at 50 – 25 / 25 or 100%.
I hope this helped.”
I think you’re saying move the negative from the denominator to the numerator, right?
But… it’s not true 100% growth though. It really “gained” $75— from -$25 to $0 and then $0 to $50. So, would you say 75/ 25 = 300%?
I’d say not. 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% [or using your calc: 105%]. So the same ending $50, but the company starting at -$25 had higher/the same growth (300% or your 100%) 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 it started at -$1 then went to $50. That’s 4900%. uhhhhh– no. See what I mean?
It isn’t that hard for a company to book a profit. Hundreds do every year. To call a company high growth when they started at a negative isn’t growth at all. It’s an improvement, sure, but not real growth. It’s just getting back to even– if you will.
Calculating growth from a lower positive number always shows real growth. Always. Bottom line: you can’t calculate growth from a negative earnings year because it’s not a reliable measurement. The math doesn’t check out, and the logic doesn’t check out. Definitely something more investors need to know.
Does that make sense?
“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 to not reward companies who had major losses the year before.
A company who dug itself out of a big hole isn’t necessarily stronger; you can argue it shouldn’t have gotten in the hole in the first place. A company who didn’t get into such a hole probably is stronger.
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. Cheers.