Look Beyond the Headlines
When investors look at how a company is doing one of the first things they look at is earnings per share and rightfully so. Earnings per share can tell you a lot about the history and the current state of the company. Earnings per share represent how much profits that a company makes for each ownership interest of the company.
Earnings per share are easy to calculate. It's simply the following formula:
Earnings per share are one of the common metrics that dividend growth investors use to determine the safety of the dividend and its growth potential. That makes it especially important to figure out how companies are growing their earnings per share because not all growth is created equally.
The formula is very straightforward, but there's a lot more that's going on behind the scenes when you break it down into its components.
How do companies grow their earnings per share?
Companies have 3 levers to pull in order to grow their earnings per share.
- Increase Revenue/Sales
- Decrease Costs/Expenses
- Decrease Shares Outstanding
All 3 of these levers are needed in order to grow earnings per share, but determining which ones are at play for the companies you own is important in figuring out whether the growth is real or engineered.
(1) Increase Revenue/Sales
This is the lever you want to see doing the heavy lifting for growing earnings per share. If revenues are constantly growing then everything else being equal earnings per share will rise as well. Growth is sales is the best way for a company to grow earnings because it means the company is firing on all cylinders through brand power = price increases, selling more product, taking more market share or expanding into new products.
Check out this post for a more detailed look at the 5 ways companies can grow.
(2) Decrease Costs/Expenses
Keeping costs in check is another great way that companies can increase earnings per share. Cost cutting or optimization should be something that companies look for at all times. However, it seems to be in managements' cross-hairs only when times are tough. That could mean the economy as a whole is contracting or the company is hitting temporary setbacks. No matter the reason companies can use cost cutting to improve operations. Whether that's doing more with less personnel or making improvements to their operations.
Cost cutting is a great tool that management can use because it can free up cash for other uses. The problem is that cost cutting has a natural limitation and can't be done forever. Reducing expenses also doesn't lead to top line growth for the company, but rather just makes the flow of money through a business more efficient.
Due to the limited nature of cutting expenses this is a lever you want to see companies explore, but not focus on entirely because it's not a sustainable way to grow earnings per share over the long term.. Time and money would be better spent on growing the top line or revenue.
(3) Decrease Shares Outstanding
The last lever that companies have to grow earnings per share is to reduce the denominator, the shares outstanding. For example, if a company has $100 in profits and is divided into 100 shares each shares' claim on the profits is $1.00. If one year a company is able to buy back 10 shares, but still makes $100 in profits the "profit pie" is cut into less pieces. Each shares' claim on the profits has now increased to $1.11. That's an 11% gain because the share count has been reduced.
Share buybacks are great because they will always lead to growth in earnings per share, but there's some major caveats to watch out for. One thing you don't want to see from the companies you own is all of the earnings per share growth coming from share buybacks. Yes, a company can do quite well by reducing the share count, but without true top line growth in revenue the company could be signaling that they don't have better growth opportunities in the works or even worse the company could be in decline.
The second big caveat to watch out for with share buyback is to make sure they are actually reducing the share count. Quite often companies will report that they spent a large sum on buybacks, but what they don't openly state is that only 50% of that money reduced the share count while the other 50% just negated the dilutive effects of stock options to pay executives. This fact will show up in the earnings per share figure, but it's important to analyze how effective the share buybacks really are.
Rising earnings per share is a great sight for dividend growth investors. When you find a company that continually grows earnings and also rewards shareholders with higher dividends that can lead to wealth generation over the long term. After all, a higher earnings per share can support a higher dividend payment which is what we all want to see.
However, it's important to look deeper into how the companies are generating that growth because not all growth is created equally.
The growth you want to see doing the heavy lifting of a rising earnings per share is true, organic growth in revenues. This is the best growth to see when you analyze how the underlying businesses are performing.
The other two ways companies can grow their earnings per share will do the trick; however, they aren't the ones you want to see doing the majority of work.
There's a natural limit to the amount of expenses that a company can cut without suffering a decrease in productivity or reducing the exploration of other true organic growth avenues. That's why cost cutting is something you like to see, but there's only so much that a company can do to effect the profits of the company.
The last option, share count reduction, can be a great use of a company's capital because it's an easy way to generate growth. However, I don't like to see the majority of earnings per share growth coming from share buybacks because they don't grow the top or bottom line, rather they just divide it into fewer pieces.
While the headline numbers get all the attention, as part of your due diligence it's important to look beyond the headlines to truly understand how the companies are obtaining the growth in earnings per share.
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