Growth Rate in Earnings per Share - Formula & Example

Earnings Per Share (EPS) growth rate is a key financial metric used to assess a company's ability to grow its earnings over a specified period. It is expressed as a percentage and represents the annualized rate at which a company’s earnings per share (EPS) is increasing or decreasing from one period to the next. EPS is calculated by dividing a company's net income by the number of outstanding shares of common stock. The EPS growth rate is used by investors and analysts to evaluate a company's profitability trends and potential for future earnings growth.

The Importance of EPS Growth Rate

Earnings Per Share (EPS) is a crucial financial metric that measures a company’s profitability on a per-share basis, and it plays a significant role in determining a company’s overall financial health. EPS growth rate, which reflects the change in EPS over time, is particularly important for investors and analysts as it provides insight into the future potential of a company. A consistent increase in EPS growth can signal a company’s ability to generate higher profits, making it an attractive investment. However, like any financial metric, the EPS growth rate comes with its own limitations. Understanding both the significance and limitations of EPS growth is essential for investors seeking to make informed decisions.

1. Indicator of Company Performance

EPS growth rate is often considered one of the most reliable indicators of a company’s overall financial performance. A positive and consistent increase in EPS typically signifies that a company is effectively managing its operations, increasing its revenues, and improving its cost-efficiency. This is usually viewed as a sign of strong operational performance and robust financial health.

When a company consistently reports growth in its EPS, it suggests that the company is not just generating profits but is doing so in an efficient manner. For example, it might indicate that the company is able to scale its operations without a proportional increase in costs. Furthermore, an increase in EPS often reflects the successful execution of the company’s business strategy, whether it involves product innovation, market expansion, or improved operational processes. Investors see this growth as a sign of management’s ability to navigate the complexities of the business environment and drive the company toward continued success.

2. Investor Insight

Investors often look at EPS growth rate as a key indicator when evaluating the future prospects of a company. A company that consistently demonstrates a strong growth trajectory in its EPS is typically seen as a more attractive investment opportunity. High and steady EPS growth usually signals that a company has strong profit potential and can maintain its upward trajectory in the future, which is a fundamental concern for investors looking for capital appreciation.

Moreover, EPS growth can serve as a predictor of future performance. If a company is expanding its earnings efficiently, it might indicate that its market position is strengthening, which could lead to further revenue and earnings growth. For investors, this consistency can be reassuring, especially for those interested in companies that can generate consistent returns over time. Furthermore, EPS growth may also be indicative of a company's ability to weather economic downturns or market volatility, providing investors with confidence in its long-term prospects.

3. Comparison with Peers

EPS growth rate is particularly useful for comparing the performance of companies within the same industry. By examining the EPS growth of different companies, investors can gain valuable insights into which firms are outperforming their peers. A company with a higher and more consistent EPS growth rate is likely outperforming others in terms of profitability and operational efficiency, which could reflect stronger management, superior products or services, or a competitive advantage.

In industries where competition is fierce, a company with a higher EPS growth rate might also suggest that it is gaining market share or benefiting from favorable economic conditions. This is important for investors looking to choose between companies operating in the same sector. If one company stands out with consistently better EPS growth, it may offer a more compelling investment opportunity than its competitors.

4. Valuation Tool

EPS growth rate is a critical component in various valuation models. A higher EPS growth rate often leads to a higher valuation, as investors are typically willing to pay a premium for companies with strong future growth prospects. Two common valuation models that rely heavily on EPS growth are the Price-to-Earnings (P/E) ratio and discounted cash flow (DCF) analysis.

The P/E ratio, for instance, is calculated by dividing a company’s current share price by its EPS. Investors often use this ratio to determine if a company’s stock is overvalued or undervalued relative to its earnings. A company with strong EPS growth may justify a higher P/E ratio, as investors expect future earnings to continue to grow, and thus are willing to pay more for the stock today. Similarly, in DCF analysis, the projected future cash flows of a company are discounted to present value based on an assumed EPS growth rate. In both cases, a higher EPS growth rate can result in a higher valuation, which can impact an investor’s decision on whether to buy, hold, or sell shares.

5. Long-Term View

The EPS growth rate is typically analyzed over an extended period—often five years or more—in order to smooth out any short-term volatility. This long-term perspective is essential because it offers investors a clearer view of a company’s consistent performance and helps eliminate any fluctuations caused by seasonal or temporary factors. By looking at EPS growth over a longer time frame, investors can better assess whether the company’s earnings growth is sustainable and whether the growth is driven by fundamental improvements in operations or by external factors.

Short-term fluctuations in EPS growth can be caused by a variety of factors, such as changes in market conditions or temporary inefficiencies. However, by examining longer-term trends, investors are better able to focus on the company’s core performance. For instance, if a company has consistently grown its EPS over the past five or ten years, it may suggest that the company has solid foundations and a sustainable competitive advantage, making it a more reliable long-term investment.

Limitations of EPS Growth Rate

While EPS growth rate is an important metric for evaluating a company’s performance, it has its limitations that investors must be aware of when making decisions.

1. One-time Events

One of the significant limitations of EPS growth rate is that it can sometimes be distorted by one-time or non-recurring events. For example, a company might experience a temporary spike in EPS due to asset sales, restructuring charges, tax benefits, or changes in accounting practices. These one-time events can artificially inflate or deflate EPS for a given period, leading to misleading growth rate figures.

For instance, if a company sells a portion of its business at a high price, it could generate a one-time gain that boosts its EPS for that quarter. However, this gain does not reflect ongoing operations and may not be indicative of future earnings. Therefore, it is crucial for investors to differentiate between organic growth and growth driven by one-time events when analyzing EPS growth rates.

2. Debt Levels

Another limitation of EPS growth rate is its inability to account for a company’s debt levels. A company with high levels of debt may show an increased EPS growth rate due to the effects of financial leverage. Leverage amplifies the potential returns on equity, meaning that even small increases in revenue or profitability can lead to large increases in EPS.

However, this growth may not reflect actual operational performance and could be a result of increased debt rather than improved business fundamentals. Investors should take debt levels and other financial metrics, such as debt-to-equity ratio, into account when interpreting EPS growth, as excessive leverage can lead to higher financial risk in the long run.

3. Dividend Adjustments

Finally, changes in a company’s dividend policy or share buyback programs can also impact EPS growth. When a company buys back its own shares or increases its dividend payouts, it reduces the number of shares outstanding, which can lead to a higher EPS figure, even if the company’s actual net income has not increased significantly.

While share buybacks and dividends can be beneficial to shareholders in the short term, these actions do not necessarily reflect underlying operational growth. Therefore, investors should be cautious and ensure that they are not overestimating a company’s performance based solely on changes in its dividend policy or share buybacks.

 
Formula:
EPS Growth Rate = (EPS at end - EPS at beginning) / EPS at beginning

Example 1:
The common stock of Company B has an EPS of $1.50 in Year 1, and $2.00 in Year 2. Thus, the change in EPS = 2.00 - 1.50 = $0.50, and then you simply divide the change in EPS by the earnings per share at beginning to get the Earnings Per Share growth rate:
(0.50 / 1.50) * 100% = 33.33%

Example 2:
Following are the earnings per share for the past 4 years:
2007 - $0.30
2008 - $0.55
2009 - $0.80
2010 - $1.00
Calculate the earnings per share growth rate.

Solution:
Year 2008 = (0.55 - 0.30) / 0.30 = 83.3%
Year 2009 = (0.80 - 0.55) / 0.55 = 45.5%
Year 2010 = (1.00 - 0.80) / 0.80 = 25%