When it comes to investing, the first thing I consider about a company is dividend growth.  I prefer to invest in companies that have at least a 5 year history of annually increasing their dividend payment to shareholders.  For me, a company that is able to grow it’s dividend over a period of time is usually a successful company.  Also, management is showing their faith in the future performance of a company by committing to pay out a higher and higher dividend to owners.

While I believe dividend growth signals great companies, there is another growth metric I believe to be the most important when considering an investment.  The number one thing I look for in investments and do not want to compromise when deciding which companies deserve a spot amongst my portfolio is earnings per share (EPS) growth.

Earnings Per Share Growth is the Driver of Wealth

As a shareholder of a company, the most important bottom line number for me is the earnings per share (EPS).  When I buy stock, I am an owner of that company.  Each share I own is worth a small fraction of the company.  The total amount of the company I own depends on how many shares I own.

The earnings per share amount is simply the total net profits of a company dividend by the number of shares outstanding.  To calculate my portion of the earnings, I can take the EPS amount multiplied by the number of shares I own.  This is technically my portion of the profits of the company.  Now management of the company will decide what to do with those profits.  They can reinvest back into the company or pay out profits to shareholders in the form of dividends.

As an investor, I want my company to grow in value over time.  The way for a company to achieve this is by growing their earnings per share.

For example, lets say I purchase a company with EPS of $1.00.  Let’s say I pay a price of 10 times earnings or $10 per share.  Over time I expect management to do a good job growing the company.  If over the course of a few years they are able to double the amount of EPS I am earning to $2.00 and the market is still pricing the company at 10 times earnings, then my shares will be worth $20 each.

So the first way EPS growth creates wealth is because as EPS grows the value of the shares I own grow.  This is why I look to invest in companies that have proven they can consistently grow earnings over time.  By growing their EPS, the company is making each individual share worth more.

As a dividend growth investor, I like to receive part of my portion of the company’s earnings in the form of a dividend payment every quarter.  Currently I am reinvesting my dividends in order to take advantage of compounding to grow my wealth.

Earnings per share growth is very important to dividend growth investors.  Looking at the example from above.  If the company I purchased that was earning $1.00 per share is unable to grow their earnings over time, do you think they will be able to pay me an increasing dividend over time?

Companies cannot pay out more than they earn over long periods of time.  At some point a dividend that is higher than EPS will become unsustainable.

However, if that same company is able to grow earnings per share, they can also grow my dividend payment right along with it.  Therefore, EPS growth is the lifeblood to dividend growth.  Without growth in EPS, there cannot be sustainable growth in the dividend.

This is why it is vitally important to only invest in companies that have a proven history of EPS growth.  Of course past performance does not guarantee future results.  But I’ll take my chances with a proven performer any day compared to a company that hasn’t shown the ability to grow earnings over time.

The Two Things I’m Looking for in EPS

  1. Consistently trending upwards.  When I am looking at the 10 and 15 year financial data of a company, I like to see companies that generally have a growing trend in EPS.  I look for companies who have demonstrated the ability to grow thier bottom line for thier investors year after year.  It’s alright to have a down year or two every once in awhile.  In fact a down year can provide good buying opportunities for investors as long as they are confident the company will turn things around shortly.  However, I want to make sure the growth trend is generally up and consistent, not sporadic.
  2. A decent earnings per share growth rate.  When evaluating a company I always calculate the 10 year compounded annual growth rate of the EPS.  The higher the growth rate the better.  Generally I look for a growth rate of at least 5% on average.  This earnings per share growth is the driver of all future returns from a company.

 Two Examples of Dividend Growth Companies and EPS Growth

1.) Diebold Inc (DBD) is one of the longest dividend growers having raised their dividend payment annually for 60 years in a row.  This might lead one to believe this is a great company for dividend growth investors to own.  However, a look at their EPS data over the past 10 years paints a very different picture.

Year 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003
EPS 1.28 2.23 -0.31 1.09 1.52 0.59 1.29 1.17 2.54 2.4

As you can see, the EPS has been very sporadic for Diebold over the past decade.  There have been some good years followed by some very bad years.  In fact, you can see that had you purchased shares back in 2003, your shares are earning significantly less now almost 10 years later.  The performance of Diebold for investors over the past decade has not been good.  Earlier this year the CEO of Diebold was pushed out due to the poor performance of the company.  This is not the kind of company dividend growth investors want to be an owner of.

2.)  Walgreen’s (WAG) is a retail pharmacy that has been increasing dividend payments to investors annually for the past 37 years.  This is another company with a long history of dividend growth.  Let’s take a look at their past 10 years worth of EPS data.

Year 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003
EPS 2.42 2.94 2.12 2.02 2.17 2.03 1.72 1.52 1.32 1.14

Looking over that chart, we can see that Walgreen’s has done a good job growing earnings over the past decade.  In fact, EPS have more than doubled!  Now it hasn’t been the smoothest of rides.  Like most companies, WAG had a couple down years during the recession in 2009 and 2010.  However, they recovered nicely.  More recently, WAG had a dispute with prescriptions benefit manager Express Scripts.  This weighed on the 2012 EPS data.  This dispute has since been resolved and investors expect Walgreen’s to recover over time.  Mostly, Walgreen’s EPS trend is upward and there is good growth in the data.  This is the kind of company dividend growth investors should want to own.

On a side note, events such as the recession and the Express Scripts conflict can give investors great opportunities to pick up shares of wonderful companies at discounted prices.  As long as an investor is confident that the company can recover and improve performance going forward, they should feel good getting a discount on the shares of great companies.  In fact, I took advantage of the Express Scripts conflict and purchased shares in Walgreen’s at a great valuation.  The company has since recovered, and my WAG investment has so far been my best performer.

Conclusion

In conclusion, the EPS growth is the most important driving force behind the creation of wealth.  EPS growth will allow companies to continue growing our important dividends over time.  Also the EPS growth will continue to push up the value of the shares we own.  Look for companies that are growing their earnings in a consistent up trend.  These types of companies should turn out to be good long term investments providing the foundation to a solid financial future.

What do you think?  Is EPS growth that important?  Are you willing to compromise when it comes to past EPS performance from companies you look to invest in?  Please share your thoughts in the comments below!

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8 Responses to Earnings per Share Growth: The Creator of Wealth

  1. Ben says:

    Good one. I agree that growth in earnings is important, especially the consistency of the growth from year to year.

    Another one I like to look at is growth of book value. If you think about it, book value is the amount leftover to shareholders after all liabilities have been paid off from your assets. Buffett uses book value to measure Berkshires performance over the years.

    • Dan Mac says:

      Thanks for the comment Ben! I agree that book value is another good metric to pay attention to. There are actually quite a few fundamental metrics I like to look at when evaluating companies. It’s important to check everything out and not rely on just one measure. But for me, always the first metric I like to make sure is up to my standards is the growth in EPS. Other metrics I may be more lenient on, but not the EPS growth.

  2. Martin says:

    Dan, I am a bit confused about using EPS and EPS growth. Many times I have read that this metric can be manipulated in books. Although I wouldn’t expect doing such thing by a good and serious company, but I still rather look at cash flow and cash flow growth (usually in conjunction with EPS, I admit).

    • Dan Mac says:

      Thanks for the comment Martin. While I agree there are certain ways companies might manipulate one years EPS compared to another, I don’t think they have the ability to do this long term. That is why it is important to look at the long term growth figures.

      Like you stated though, I also look at many other metrics in conjunction with EPS. You cannot simply look at one financial metric of a company and make a good decision of whether it is a buy or a sell. You must look at many different variables and take them all into consideration. However, for me the most important is EPS growth.

  3. Integrator says:

    Dan, Interesting post. I actually really believe that revenue growth is the key driver for wealth, its certainly one that i focus on more. Ultimately companies can cut cost and buy back shares to boost EPS, but that can only get you so far over the long term. I’d rather a company drives revenue than focus incremental efforts on cost mitigation to boost EPS. I’d be willing to overlook several years of poor EPS performance if top line revenue growth was strong, and costs happen to blow out.

    • Dan Mac says:

      Thanks for the comment Integrator!

      For me it is all about the bottom line and the EPS is the bottom line for a shareholder. With that said, I certainly don’t want to lead on that I only look at EPS growth to make investment decisions. I am also looking at many other metrics, one being revenue growth. Like you said, if EPS is growing because of cost cutting or share repurchases then that can only take you so far. There must be sales growth as well for a company to continue growing it’s bottom line.

      As for revenues growth alone, I would not be particulary excited about a company who is able to grow revenues without that translating to the bottom line EPS. It does me no good if a company’s costs increase right along with revenue growth negating out any positive impact to the bottom line.

      I always look for EPS growth first. But after looking at EPS growth it is very important to do a complete analysis of a company by looking at many other metrics including sales, debt levels, dividend growth and others.

  4. I prefer to look at revenue growth and cash flow rather than EPS, although I do still track EPS and EPS growth. EPS is too easily manipulated by one time items so if you’re going to focus on EPS then it’s important to really look into the numbers. Some companies/financial websites post the EPS numbers excluding one time items which I think is better to look at. Take JNJ for example, if you look at their EPS for the last few years it looks like they took a huge hit, although backing out the one time items due to the recalls then I think they actually grew the EPS every year. Of course is the non-recurring items continually recur then that is a sign to me that something is messed up with the company.

    • Dan Mac says:

      Thanks for your thoughts JC! For me it is all about the bottom line. That is the EPS. Taking into consideration one time items is certainly important but make sure they are in fact one time items and not frequent events. One thing I certainly don’t like to see is a company charging off one time items every year after year.

      I think revenue growth and cash flow are also important to review. However, I believe that the price of the stock over time will follow along nicely with EPS growth. If the company has strong cash flow and revenue growth that is not translating into the bottom line EPS, then management isn’t doing their job properly. However, most of the great dividend growth companies are doing a solid job growing revenues and EPS while maintaining strong positive cash flow providing safe dividend income for investors.

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