Estimating EPS-Growth rate

You know what EPS is. It’s earnings per share. EPS-GR stands for Earnings per share growth rate. This estimated growth rate is an important figure for valuing a company. When you compare the EPS history with the stock price history, it helps you determine the most likely future direction of the stock price.

  • Take note: In calculating a company’s earnings growth rate, you need to decide whether growth should continue at that same rate. Studying the firm, its products, and its competitive environment will help guide your decision to adjust the growth rate up or down.

Why is EPS-GR important?

Let me clarify with an example.

  • Let’s compare two stocks – stock of AB Ltd with an EPS of 5 and stock CD ltd with an EPS of 7.
  • At once glance, you may think that stock CD Ltd is better since it has an EPS of 7
  • A year later, AB Ltd has EPS of 5.50 per share while CD Ltd has an EPS of 7.50 per share.
  • This means, AB Ltd has grown 10% whereas, CD ltd has grown only 7.14%
  • Naturally, the price of AB Ltd will increase higher than stock CD. The stock price has direct relationship with the EPS and hence you will be getting more profit from a stock that has higher EPS-Growth rate.

Stock with the highest EPSGR rises fastest in that year as compared to its competitors in the same industry. If a company maintains a 10% or more EPS growth rate, that company may be a good target. However, such growth rates in EPS are more reliable in the case of ‘matured companies’ which has experienced a complete economic cycle of expansion and contraction, through a bear market phase and a bull run. New and fast growing companies may not have such a financial history to rely upon and may exhibit greater volatility in earnings history. Earnings history of such new and fast growing companies is less reliable in projecting growth rates than large matured companies with a consistent earnings history of 10 years or more.  So, the chances of accuracy in predicting EPS growth increases for companies with greater financial history.

Calculation.

To calculate the growth rate in earnings of a company, let’s take an example. Let’s assume that the earnings per share (EPS) of a company is as follows:

Year    EPS

2011:  4.50

2010:  4.20

2009:  3.90

2008:  3.45

2007:  2.80

2006:  2.10

In the five years from 2006 to 2011 the earnings per share increased from 2.10 to 4.50 and the growth has been consistent. In such cases, the first step is to calculate the growth multiple.

  • Growth multiple =   4.50/2.10 = 2.14

Next we raise the growth multiple of 2.14 to the 1/5th power:

  • (2.14)1/5 = 1.164

1/5th power has been used because we are calculating for 5 years. If the time period was three years, we use the 1/3rd power.

Next we take the 1.164 figure and subtract 1:

  • 1.164 – 1 = 0.164

As a final step, we multiply .164 by 100 to get the average annual growth rate.

  • 0.164 x 100 = 16.40% is the average annual growth rate.

From the historical and qualitative analysis, you have to take a decision as to what would be the rate of growth for the company in future. It’s your call. You can assume it as 16.40% or you can play safe by assuming a lower growth rate of 12% or 10%. It’s your decision.

Ideal growth rate.

If you are looking to invest in a company that’s consistent, you have to make sure that the company in question has a consistent earnings growth history of at least 10%.

Most of the start up companies may not have such a consistent history of earnings. Some times, you may come across companies with strong fundamentals but with low annualized EPS of less than 4 or 5 % but analysts may talk about a huge turnaround in the earnings due to heavy order book. Keep watch on such companies.  Research and find out if there’s some fact in it. You could be near to spotting a high growth company.

You may like these posts:

  1. Stock investing strategy – Growth investing
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  3. Eight point checklist for history scan

6 Responses to “Estimating EPS-Growth rate”

killivalavan

February 14, 2012 at 5:27 am

Good post . Will this formula works if EPS is not growing sequentially? or maybe in negative EPS?

J Victor

February 14, 2012 at 3:29 pm

Yes it works.

Mansoor

February 14, 2012 at 11:23 pm

Excellent article, very easy to understand the calculation. Thanks for sharing.

YK Lau

January 19, 2013 at 7:09 am

Thanks, it’s very useful because I’ve been looking around for the method to calculate EPS GR.

J Victor

January 21, 2013 at 8:26 am

@ YK lalu thanks:)

Pankaj Gosain

May 20, 2016 at 12:55 pm

very useful article.

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