Conventional Valuation Yardsticks: Earnings and Earnings Growth

Earnings and Earnings Growth

Earnings per share has historically been the valuation yardstick most commonly used by investors.

Unfortunately, as we shall see, it is an imprecise measure, subject to manipulation and accounting vagaries.

It does not attempt to measure the cash generated or used by a business.

And as with any prediction of the future, earnings are nearly impossible to forecast.


Massaging earnings by managements

Corporate managements are generally aware that many investors focus on growth in reported earnings, and a number of them gently massage reported earnings to create a consistent upward trend.

A few particularly unscrupulous managements play accounting games to turn

• deteriorating results into improving ones, 
• losses into profits, and 
• small profits into large ones.

Earnings can mislead as to the real profit.

Even without manipulation, analysis of reported earnings can mislead investors as to the real profitability of a business.

Generally accepted accounting practices (GAAP) may require actions that do not reflect business reality.

• By way of example, amortization of goodwill, a noncash charge required under GAAP, can artificially depress reported earnings; an analysis of cash flow would better capture the true economics of a business. 
• By contrast, nonrecurring gains can boost earnings to unsustainable levels, and should be ignored by investors." 

Most important, whether investors use earnings or cash flow in their valuation analysis, it is important to remember that the numbers are not an end in themselves. Rather they are a means to understanding what is really happening in a company.




Conventional Valuation Yardsticks: Earnings, Book Value, and Dividend Yield

Both earnings and book value have a place in securities analysis but must be used with caution and as part of a more comprehensive valuation effort.

Do you always avoid all companies with large amounts of debt?

In an ideal world, you will select to invest in companies that produce consistently high returns and have low levels of debt.

This is the essence of quality and safe investing.

Do you always avoid all companies with large amounts of debt?

Not necessarily.



When larger debts are not a problem

There are some companies which can cope with higher levels of debt and still potentially make good investments.

These are companies with very stable and predictable profits and cash flows.

They have consistently high debt to total asset ratio and quite low levels of interest cover, and yet, they have many of the hallmarks of a quality company.

They have

• grown their sales, profits (EBIT) and free cash flows, 
• whilst maintaining high profit margins (EBIT margins) and 
• very good levels of ROCE.

The general point is:  if a company shows it can continue to increase turnover and EBIT - sales and profit - year after year, whilst holding high levels of debt, this can still be regarded as a quality company and potentially a good investment.

Look at growth from the perspective of investment required to support the growth. Profitable Growth Occurs Only Within a Franchise.

Summary 
Now to summarize about growth:

1. growth at a competitive disadvantage destroys value,
2. growth on a level playing field neither creates nor destroys value, and
3. it is only growth behind the protection of barriers to entry that creates value.

Growth 
 

The standard view of short term analysts is that growth is your friend. Growth is always valuable.  That is wrong!  
 

Growth is relatively rarely valuable in the long run. And you can see why with some simple arithmetic.  I am not going to look at growth from the perspective of sales, I am going to look at it from the perspective of investment required to support the growth. 

• Now the investment required to support the growth is zero then of course it is profitable—that happens almost never (For Duff & Phelps or Moody’s perhaps). 
• At a minimum you have A/R and other elements of working capital to support growth. 

Suppose the investment required is $100 million, and I have to pay 10% annually to the investors who supplied that $100 million dollars.   The cost of the growth is 10% of $100 million or $10 million dollars.   

1.  Suppose I invest that $100 million at a competitive disadvantage. 

• Suppose I am Wal-Mart planning to compete against a well-entrenched competitor in Southern Germany, am I going to earn 10% on that investment?  Almost never.  In that case, I will be lucky to earn anything; perhaps I earn $6 million. 
• But the net contribution of the growth is the $10 million cost of the funds minus the $6 million benefit which is minus $4 million dollars for every $100 million invested. 
• Growth at a competitive disadvantage has negative value.  

 

2.  Suppose it is like the automotive industry or like most industries with no barriers to entry, it is a level playing field so the return will be driven to 10% cost by the entry of other competitors. 

• So I am going to pay $10 million, I am going to make $10 million so the growth has zero value.   

3.  Profitable Growth Occurs Only Within a Franchise 

• The only case where growth has value is where the growth occurs behind the protection of an identifiable competitive advantage. 
• Growth only has value where there are sustainable competitive advantages. 
• And in that case, usually, what barriers to entry means is there are barriers to companies stealing market share from each other.
• There is usually stable market share which is symptomatic of that last situation that means in the long run, the company will grow at the industry rate. 
• And in the long run, almost all industries grow at the rate of global GDP.   

So in these three situations, the growth only matters in the last one where its profitable (growing within a franchise) is.

• And the critical issue in valuation is either management or the G&D approach will tell you the extent to which that is important or you have a good reliable valuation and there is no value to the growth because there are no barriers to entry. 
• Or it is down here (growth is profitable) and there obviously you want to get the growth for free.
• You could pay a full earnings power value and get a decent return. (Buffett with Coke-Cola in 1988).  

Introduction to a Value Investing Process by Bruce Greenblatt at the Value Investing Class Columbia Business School 
Edited by John Chew at Aldridge56@aol.com                           
studying/teaching/investing Page 27

Notes from video lecture by Prof Bruce Greenwald
http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf

Buffett investment thought process

Answering the following questions will guide you through the Buffett investment thought process.

QUALITY AND MANAGEMENT ANALYSIS

1.  Does the company have an identifiable durable competitive advantage?

2.  Do you understand how the product works?

3.  If the company in question does have a durable competitive advantage and you understand how it works, then what is the chance that it will become obsolete in the next twenty years?

4.  Does the company allocate capital exclusively in the realm of its expertise?

5.  What is the company's per share earnings history and growth rate?

6.  Is the company consistently earning a high return on equity?

7.  Does the company earn a high return on total capital?

8.  Is the company conservatively financed?

9.  Is the company actively buying back its shares?

10.  Is the company free to raise prices with inflation?

11.  Are large capital expenditures required to update plant and equipment?

PRICE ANALYSIS

12.  Is the company's stock price suffering from a market panic, a business recession, or an individual calamity that is curable?

13.  What is the initial rate of return on the investment and how does it compare to the return on risk free Treasury Bonds?

14.  What is the company's projected annual compounding return as an equity/bond?

15.  What is the projected annual compounding return using the historical annual per share earnings growth?

Be conservative in your estimates for future growth.

Never estimate future earnings growth:

• to exceed the growth of sales
• to exceed 20 percent
• to exceed its historical growth rate
• to exceed the analysts' estimates.

Be conservative in your estimates for future growth.  It's always better to underestimate than to overestimate.

Confine your study to companies with good sales or earnings growth.

Don't bother to continue with a stock study if sales or earnings growth is inadequate.

Sales growth is inadequate if it is below the guidelines for the size of the company you are studying (ranging from around 7 percent for a large company to 12 percent for a smaller one).

Earnings growth should be around 15 percent or better; but you can accept slower growth from companies whose dividends contribute substantially to the total return.

How To Evaluate The Quality Of EPS and find out what it's telling you about a stock.

Examining Earnings Quality

Overview  

The evaluation of earnings per share should be a relatively straightforward process, but thanks to the magic of accounting, it has become a game of smoke and mirrors. This, however, does create opportunities for investors who can evaluate the quality of earnings over the long run and take advantage of market overreactions.

EPS Quality  

High-quality EPS means that the number is a relatively true representation of what the company actually earned (i.e. cash generated).  But while evaluating EPS cuts through a lot of the accounting gimmicks, it does not totally eliminate the risk that the financial statements are misrepresented. While it is becoming harder to manipulate the statement of cash flows, it can still be done.

A low-quality EPS number does not accurately portray what the company earned.  A reported number that does not portray the real earnings of the company can mislead investors into making bad investment decisions. 

How to Evaluate the Quality of EPS

The best way to evaluate quality is to compare operating cash flow per share to reported EPS. While this is an easy calculation to make, the required information is often not provided until months after results are announced, when the company files its 10-K or 10-Q with theSEC.

To determine earnings quality, investors can rely on operating cash flow. 

1.  Positive earnings but negative Operating cash flow.

• The company can show a positive earnings on the income statement while also bearing a negative cash flow. 
• This is not a good situation to be in for a long time, because it means that the company has to borrow money to keep operating. And at some point, the bank will stop lending and want to be repaid. 
• A negative cash flow also indicates that there is a fundamental operating problem: either inventory is not selling or receivables are not getting collected.
• "Cash is king" is one of the few real truisms on Wall Street, and companies that don't generate cash are not around for long.

2.  Operating cash flow > earnings 

• If operating cash flow per share (operating cash flow divided by the number of shares used to calculate EPS) is greater than reported EPS.
• In this case, earnings are of a high quality because the company is generating more cash than is reported on the income statement. 
• Reported (GAAP) earnings, therefore, understate the profitability of the company.

3.  Operating cash flow < earnings

• If operating cash flow per share is less than reported EPS, it means that the company is generating less cash than is represented by reported EPS. 
• In this case, EPS is of low quality because it does not reflect the negative operating results of the company.
• Therefore, it overstates what the true (cash) operating results. 

Trends Are Also Important

Because a negative cash flow may not necessarily be illegitimate, investors should analyze the trend of both reported EPS and operating cash flow per share (or net income and operating cash flow) in relation to industry trends.

• It is possible that an entire industry may generate negative operating cash flow due to cyclical causes.
• Operating cash flows may be negative also because of the company's need to invest in marketing, information systems and R&D. In these cases, the company is sacrificing near-term profitability for longer-term growth.

Evaluating trends will also help you spot the worst-case scenario, which occurs when a company reports increasingly negative operating cash flow and increasing GAAP EPS. 

• As discussed above, there may be legitimate reasons for this discrepancy (economic cycles, the need to invest for future growth), but if the company is to survive, the discrepancy cannot last long. 
• The appearance of growing GAAP EPS even though the company is actually losing money can mislead investors. This is why investors should evaluate the legitimacy of a growing GAAP EPS by analyzing the trend in debt levels, times interest earned, days sales outstanding and inventory turnover.

The Bottom Line

Without question, cash is king on Wall Street, and companies that generate a growing stream of operating cash flow per share are better investments than companies that post increased GAAP EPS growth and negative operating cash flow per share. 

Earnings increasing and Operating cash flow increasing > Earnings increasing but negative operating cash flow

The ideal situation occurs when operating cash flow per share exceeds GAAP EPS. 

Operating cash flow > Earnings

The worst situation occurs when a company is constantly using cash (causing a negative operating cash flow) while showing positive GAAP EPS. 

Positive Earnings but negative operating cash flow.

Luckily, it is relatively easy for investors to evaluate the situation. 

http://www.investopedia.com/articles/analyst/03/091703.asp

An Example
Let's say that Behemoth Software (BS for short) reported that its GAAP EPS was $1. Assume that this number was derived by following GAAP and that management did not fudge its books. And assume further that this number indicates an impressive growth rate of 20%. In most markets, investors would buy this stock.

However, if BS's operating cash flow per share were a negative 50 cents, it would indicate that the company really lost 50 cents of cash per share versus the reported $1. This means that there was a gap of $1.50 between the GAAP EPS and actual cash per share generated by operations. A red flag should alert investors that they need to do more research to determine the cause and duration of the shortfall. The 50 cent negative cash flow per share would have to be financed in some way, such as borrowing from a bank, issuing stock, or selling assets. These activities would be reflected in another section of the cash flow statement.

If BS's operating cash flow per share were $1.50, this would indicate that reported EPS was of high quality because actual cash that BS generated was 50 cents more than was reported under GAAP. A company that can consistently generate growing operating cash flows that are greater than GAAP earnings may be a rarity, but it is generally a very good investment.

How Buffett determined the combined value of Capital Cities and American Broadcasting

Murphy was named president of Capital Cities in 1964.  

Murphy agreed to sell Buffett 3 million shares of Capital Cities/ABC for $172.50 per share.

How Buffett determined the combined value of Capital Cities and American Broadcasting

Approximate yield of the thirty-year US government bond in 1985 = 10%.

Cap Cities had 16 million shares = 13 million shares outstanding plus 3 million issued to Buffett.

Market cap = 16 million x $172.50 = $ 2760 million

The present value (intrinsic value) of $ 2760 million of this business would need to have earnings power of $276 million.  ($2760 x 10%)

1984

Capital Cities earnings net after depreciation and capital expenditures = $ 122 million. 

ABC net income after depreciation and capital expenditures = $ 320 million.

Combined earnings power of these two companies = $ 442 million.

However, the combined company would have substantial debt:  the approximately $ 2.1 billion that Murphy was to borrow would cost the company $ 220 million a year in interest.

So, the net earnings power of the combined company = approximately $200 million.

Additional considerations

Capital Cities’ operating margins were 28%.

ABC’s operating margins were 11%. 

If Murphy could improve the operating margins of the ABC properties by one-third to 15%, the company would throw off an additional $125 million each year, and the combined earnings power would

= $ 200 million + $ 125 million

= $ 325 million annually.

The present value of a company earning  $ 325 million annually discounted at 10%

= ($325 million / 10%)

= $3250 million.

The per share present value of a company earning $ 325 million with 16 million shares outstanding

= $ 325 million / 16 million

=  $ 203 per share.

This gives a 15% margin of safety over Buffett’s $ 172.50 purchase price. 

The margin of safety that Buffett received buying Capital Cities was significantly less compared with other companies he had purchased.  So why did he proceed?

Murphy was Buffett’s margin of safety.   When Capital Cities purchased ABC, Murphy’s talent for cutting costs was badly needed.  With the help of carefully selected committees at ABC, Murphy pruned payrolls, perks, and expenses.  Once a cost crisis was resolved, Murphy depended on his trusted manager to manage operating decisions.  He concentrated on acquisitions and shareholders assets.

Appendix

The margin of safety that Buffett accepted could be expanded if we make certain assumptions.

1.  Buffett says that conventional wisdom during this period argued that newspapers, magazines, or television stations would be able to forever increase earnings at 6% annually - without the need for any additional capital.  The reasoning, explains Buffett, was that capital expenditures would equal depreciation rates and the need for working capital would be minimal.  Hence, income could be thought of as freely distributed earnings.  This means that an owner of a media company possessed an investment, a perpetual annuity, that would grow at 6% for the foreseeable future without the need for any additional working capital. 

Media company

Earned $ 1 million

Expected to grow at 6%.

The appropriate price to pay would be $25 million dollars for this business.

Calculation: 

Present value 

=  $ 1 million / (risk free rate of 10% - 6% growth rate)

=  $ 1 million / 4%

=  $ 25 million

Compare that, Buffett suggests, to a company that is only able to grow if capital is reinvested.  

Another business

Earned $ 1 million

Could not grow earnings without reinvested capital

The appropriate price to pay would be $ 10 million dollars for this business.

Calculation:

Present value 

=  $ 1 million / risk free rate of 10%

=  $ 10 million.

Apply the above to Cap Cities

Calculations:

6 million outstanding shares

Earned $325 million or $ 203 per share

Growth 6%

Risk free rate 10%

Present value = $325 million / (10% - 6%) = $ 8125 million

Per share value = $ 507 per share.

Present value increases from $ 203 per share to $ 507 per share.

Buffett paid $ 172.50 per share.  ($172.50 / $ 507 = 34%).  Therefore, he enjoyed a 66% margin of safety over the $172.50 price that Buffett agreed to pay.

But there are a lot of "ifs".

However, the margin of safety that Buffett received buying Capital Ciies was significantly less compared with other companies he had purchased. 

His ability to obtain a significant margin of safety in Capital Cities was complicated by several factors.  

1.  The stock price of Cap Cities had been rising over the years.  Murphy was doing an excellent job of managing the company, and the company's share price reflected this.  (So, unlike GEICO, Buffett did not have the opportunity to purchase Cap Cities cheaply because of a temporary business decline.  

2.  The stock market didn't help, either.  And, because this was a secondary stock offering, Buffett had to take a price for Cap Cities' shares that was close to its then-trading value.

What Is a Quality Growth Company? Just What Do We Mean by Growth?

What Is a Quality Growth Company?
To invest only in high quality growth companies, you will have to prospect for good candidates and then analyze and evaluate each.


Invest Only in Good Quality Growth Companies
Depending upon the size or maturity of the company, you should look for companies whose "monotonous excellence" produces consistent annual earnings growth of anywhere from 7% to as much as 20% compounded annually. As these companies grow, their share prices will ultimately follow, and your portfolio will reap the returns.

"Total Return" (the combination of both capital appreciation and divi-dend yield) is, certainly, the name of the game, but it‘s best to invest in companies whose growth, rather than dividend income, is going to provide the bulk of the return.

But it‘s not enough to simply invest in growing businesses. You should also set high standards of quality for the companies in which you invest. Companies of quality will outperform their peers, perform better in economic downturns, and/or see their share prices take large tumbles during the occasional stumble.


Just What Do We Mean by Growth?
As can be seen in the diagram above, a successful company will pass through several phases of growth:

• The startup phase when earnings are predictably below the break-even point. 
• A period of explosive growth when the percentage increase in sales and earnings can be spectacular.

• The mature growth period when revenue becomes so large that it is difficult to maintain a consistent increase in the percentage of growth.
• The period of stabilization, or decline for companies that do not continue to rejuvenate their product mix or expand their target markets.

You should invest only in companies that have a track record as a public company for at least five years and for which the data is readily available. We are therefore interested in investing in companies that are at least five years into their explosive growth periods but that have not gone past their primes. Obviously, the longer the company has had a successful track record—provided its management copes successfully with maturity—the more stable and risk-free it is apt to be.

Depending upon the size of the company, fundamental investors should expect growth rates that vary from a low of about 7% to a high of around 20%. 

• Hence, if the company is an established one with sales over the $5 billion mark, a growth rate of as little as 7% might be acceptable. (The Total Return of such a company should have a substantial dividend yield component.)
• At the other end of the spectrum, the newer company in its explosive growth period should show double digit growth. While we know that growth rates above 20% cannot be sustained forever, we look for higher growth rates as compensation for the increased associated risk.

The chart below provides a rough guideline for the kinds of growth rates that concept suggests. Anything in the light area is acceptable for companies whose revenues (sales) match the scale on the left side.



For example,

• if a company‘s sales for the current year are in the neighborhood of $300 million, we would look for a growth rate of better than 12%. 
• For a company with $1 billion in sales, we would want at least 8%. 

These are the standards of growth that we will seek for investment. Higher risk situations involving companies early in their life cycles are speculative and not of investment quality.

Statements about future earnings growth rates are opinions, not facts.

There are three main types of estimates of the future. In order of increasing sophistication, they can be referred to as the naive, the gullible, and the expert. 

• The naive forecast is based on linear trend extrapolations. 
• The gullible forecast is based on analysts' estimates, such as provided by S&P Compustat's Analysts' Consensus Estimates, ACE, or by Institutional Brokers Estimate System, I/B/E/S. 
• The expert prediction is based on rigorous systematic study of a company, its industry, and the economy.

John Neville Keynes in his Scope and Method originated the use of the term "positive" to refer to "what is" and the term "normative" to refer to "what should be."   These terms make the distinction between 

• facts about the present, on one hand, and 
• opinions about either the speculative future or an ideal state on the other hand, respectively. 

The important point here is that statements about future earnings growth rates are normative, not positive. They are opinions, not facts. 

• No one's crystal ball is any more reliable than any one else's. 
• Therefore, if not self-reliant, then one must rely on the expert opinion of others who have different agendas and conflicting interests. 

Similarly, statements about efficient and rational markets where all prices instantly converge to intrinsic value are normative, not positive. 

• They are not reality, but rather utopian ideals approached by stock markets as complex aggregates but not by individual stocks. 
• Perfectly efficient markets are necessary as a fixed standard for comparison, and thus serve a useful methodological function.

Earnings Growth: Good Growth and Bad Growth

GROWTH FIGURES FOR ANHEUSER-BUSCH

Take Anheuser-Busch. Ten-year figures to 2002, using the Value Line summaries, show the following:

Year	Earnings per share	Return on equity %	Return on capital %
1993	.89	23.0	14.9
1994	.97	23.4	15.2
1995	.95	22.2	14.3
1996	1.11	27.9	17
1997	1.18	29.2	15.6
1998	1.27	29.3	16.5
1999	1.47	35.8	17.7
2000	1.69	37.6	18.2
2001	1.89	42.0	18.8
2002	2.20	63.4	21.9

GROWTH IN EPS

For Mary Buffett and David Clark, earnings per share growth, and its ability to keep well ahead of inflation, is a key factor in the investment strategies of Warren Buffett. Earnings that are consistently increased are an indication of a quality company, soundly managed, with little or no reliance on commodity type products. This leads to predictability of future earnings and cash flows.

On the other hand, with a company whose earnings fluctuate, future cash flows are less predictable. The reasons may be poor management, poor quality or an over reliance on products that are susceptible to price reductions.

Take an imaginary company with the following earnings per share:

Year	EPS
1	2.00
2	2.25
3	2.98
4	1.47
5	1.88
6	-.65
7	2.75
8	2.20
9	1.98
10	3.01

The only conclusion that follows from these figures is that this company has good years and bad years. Year 11 might be great, it might be dreadful, or it might be average. The only certainty here is the unpredictability.

Of course, a fall in margins for one or two years may be as a result of once only factors and this can provide buying opportunities.

The difficulty is making the judgment as to 

• whether there is something permanently wrong, or 
• whether the problem has been isolated and resolved.

WARREN BUFFETT AGAIN ON GROWTH

For Warren Buffett the important thing is not that a company grows (he points to the growth in airline business that has not resulted in any real benefits to stockholders) but that returns grow. In 1992, he said this:

‘Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long term market value.
In the case of a low-return business requiring incremental funds, growth hurts the investor.’


http://www.buffettsecrets.com/company-growth.htm

PAST GROWTH AS A PREDICTABILITY FACTOR

Although a consistent record of increases in earnings per share is not of itself an absolute predictor of either further increases, or the rate of any increases,Benjamin Graham believed that it was a factor worthy of consideration.

In addition, it is logical to conclude that a company that has had regular and consistent increases in earnings per share over a protracted period is soundly managed.

COMPOUNDING EFFECT OF GROWTH

Regular growth in earnings per share can have a compound effect if all, or substantially all, of the profits are retained. 

A company, for example, with earnings per share of 40 cents growing regularly 9 % would, in ten years produce earnings per share of 87 cents.

Of course, if the investor can do better with retained earnings than the company can, his or her interests are better served by a full distribution of profits.

WHAT WARREN BUFFETT LOOKS FOR IN COMPANY GROWTH

An investor likes to see a company grow because, if profits grow, so do returns to the investor. The important thing for the investor, however, is that the company increases the returns to shareholders. A company that grows, at the expense of shareholder returns, is not generally a good investment. As Warren Buffett said in 1977:

‘Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5 % increase in earnings per share.’

WARREN BUFFETT AGAIN ON GROWTH

For Warren Buffett the important thing is not that a company grows (he points to the growth in airline business that has not resulted in any real benefits to stockholders) but that returns grow. In 1992, he said this:

‘Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long term market value.

In the case of a low-return business requiring incremental funds, growth hurts the investor.’

What Warren Buffett Looks for in Company Growth

WHAT WARREN BUFFETT LOOKS FOR IN COMPANY GROWTH

An investor likes to see a company grow because, if profits grow, so do returns to the investor. The important thing for the investor, however, is that the company increases the returns to shareholders. A company that grows, at the expense of shareholder returns, is not generally a good investment. As Warren Buffett said in 1977:

‘Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5 % increase in earnings per share.’

COMPOUNDING EFFECT OF GROWTH

Regular growth in earnings per share can have a compound effect if all, or substantially all, of the profits are retained. A company, for example, with earnings per share of 40 cents growing regularly 9 % would, in ten years produce earnings per share of 87 cents.

Of course, if the investor can do better with retained earnings than the company can, his or her interests are better served by a full distribution of profits.

PAST GROWTH AS A PREDICTABILITY FACTOR

Although a consistent record of increases in earnings per share is not of itself an absolute predictor of either further increases, or the rate of any increases,Benjamin Graham believed that it was a factor worthy of consideration.

In addition, it is logical to conclude that a company that has had regular and consistent increases in earnings per share over a protracted period is soundly managed.

WARREN BUFFETT AGAIN ON GROWTH

For Warren Buffett the important thing is not that a company grows (he points to the growth in airline business that has not resulted in any real benefits to stockholders) but that returns grow. In 1992, he said this:

‘Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long term market value.

In the case of a low-return business requiring incremental funds, growth hurts the investor.’

GROWTH FIGURES FOR ANHEUSER-BUSCH

Take Anheuser-Busch. Ten-year figures to 2002, using the Value Line summaries, show the following:

Year	Earnings per share	Return on equity %	Return on capital %
1993	.89	23.0	14.9
1994	.97	23.4	15.2
1995	.95	22.2	14.3
1996	1.11	27.9	17
1997	1.18	29.2	15.6
1998	1.27	29.3	16.5
1999	1.47	35.8	17.7
2000	1.69	37.6	18.2
2001	1.89	42.0	18.8
2002	2.20	63.4	21.9

GROWTH IN EPS

For Mary Buffett and David Clark, earnings per share growth, and its ability to keep well ahead of inflation, is a key factor in the investment strategies of Warren Buffett. Earnings that are consistently increased are an indication of a quality company, soundly managed, with little or no reliance on commodity type products. This leads to predictability of future earnings and cash flows.

On the other hand, with a company whose earnings fluctuate, future cash flows are less predictable. The reasons may be poor management, poor quality or an over reliance on products that are susceptible to price reductions.

Take an imaginary company with the following earnings per share:

Year	EPS
1	2.00
2	2.25
3	2.98
4	1.47
5	1.88
6	-.65
7	2.75
8	2.20
9	1.98
10	3.01

The only conclusion that follows from these figures is that this company has good years and bad years. Year 11 might be great, it might be dreadful, or it might be average. The only certainty here is the unpredictability.

Of course, a fall in margins for one or two years may be as a result of once only factors and this can provide buying opportunities.

The difficulty is making the judgment as to whether there is something permanently wrong, or whether the problem has been isolated and resolved.

http://www.buffettsecrets.com/company-growth.htm

One simple criterion to base stock purchases - FOCUS ON EARNINGS

Toward the end of his life, Benjamin Graham spent many hours looking for one simple criterion on which to base stock purchases.  His focus turned to EARNINGS.

"My research indicates that the best results come from simple earnings criterions."

His multiple criteria for selecting investment-quality stocks have remained the most reliable.  What makes an "investment-quality stock"?

• Financial condition is conservative and working capital position is strong. (Check the Balance Sheet).
• Earnings are reasonably stable, allowing for business conditions that fluctuate over a 10-year period. (Check the Income Statement).
• Average earnings bear a satisfactory ratio to market price. (Check the Valuation).

As investors become more familiar with these guidelines, they follow them easily and automatically, or so it seems.

Buffett and his partner, Charlie Munger, say they don't sweat over formal rules or procedures when trying to determine if a stock has growth potential.

For those of us with less talent and experience than Buffett and Munger, however, it is acceptable to work out a portfolio plan and run a checklist tally of a stock's pluses and minuses.


REMEMBER:

• Quantitative data are useful only to the extent that they are supported by a qualitative survey of the enterprise.
• The companies with the best investment potential are consistently profitable.
• The P/E ratio should be low compared with those of other companies in the same industry.
• The P/E ratio establishes the upper share price limit on intrinsic value.
• Earnings and other estimates should err on the side of understatement.  That, in itself, makes for a margin of safety.

Also read:
Ben Graham's checklist for finding undervalued stocks
https://docs.google.com/spreadsheet/ccc?key=0AuRRzs61sKqRdFpHTldITEQyZDJuVGdDY3hTS3lvQ0E&hl=en#gid=0

Have an opinion on future growth - How can the company increase its earnings?

It is only rational to have an opinion on future growth.  Otherwise, how could you ever choose a stock?

When forming that opinion, back up quantitative information with qualitative factors.

For example, ask what management is doing to make a positive impact on earnings.

According to Peter Lynch, there are 5 basic ways a company can increase earnings:

• reduce costs; 
• raise prices; 
• expand into new markets;
• sell more of its products to the old markets; or
• revitalize, close or otherwise dispose of a losing operation.

When management is enacting growth-promoting activities, earnings may be temporarily flat.  They often soon take a giant step up.

Benjamin Graham saw a vulnerability in a high growth rate and in high returns on capital - the two normally go together.

So what's there to worry about in good earnings?  Exceptionally high earnings often attract rough competitors.  

The good part is that high earnings lure enthusiastic new investors, who often bid the share into the stratosphere.


Comment:
Buy good quality growth companies.
Assess the quality of the business and the management.
Then do the valuation.
These are the basics of the QVM or QMV approach to investing.

How Value Investor identifies Earnings, Sales and Future Growth

The real goal of the value investor is to identify companies with solid financial base that are growing at a faster rate (in terms of sales and earnings) than both their competitors and the economy in general.

All things being equal, share price is likely to increase in value at about the same rate that sales grow.

For dominant companies in major industries, an investor will want a sales growth rate of 5 to 7 percent.  

Within a portfolio, look for an overall sales growth rate of at least 10% annually.

Earnings need not rise every year. Almost all industries operate in cycles, and any company can suffer a temporary setback.

But investors should be wary

• when a company's earnings and sales are erratic without explanation or 
• when sales and earnings are slowly sinking and the company is not taking corrective action.

Divine Dividends

Dividends represent nothing more than the investor's share of earnings that will be received immediately (rather than through reinvestment and future growth of the stock).

Dividends are one of the quickest and healthiest ways that earnings can make their way into shareholders' pockets.

Graham argued that intelligent investors would rather have dividends in their pockets (even if investors use them to buy more of the same stock) than risk waiting for possible future growth.  Furthermore, he insisted, it is management's responsibility to pay dividends.

For long-term investors who follow a "buy and hold" strategy, dividends are the only way to collect on investment gains.

In addition to representing money in the bank, dividends are, to many investors, a reliable indicator of future growth.  

Values are determined roughly by earnings available for dividends.  This relation among earnings, dividends and values survives.

A long history of dividend payments and regular dividend increases also indicates a substantial company with limited risk.  

Additionally, a rise in the dividend is tangible confirmation of the confidence of management in good times ahead.  A cut in the dividend is a red flag indicating trouble on the track.

Not all corporate income need be paid in dividends.  Depending on the industry and how much capital is required to keep the business growing, the appropriate payout may be as much as 80% or as little as 50% of net earnings.  

When studying the dividend payout of a company, calculate both average earnings and average dividends over a 10-year period.  From those two averages you can determine the average payout.  

Earnings fluctuate, but dividends tend to remain stable or,  in the best companies, to rise gradually.


One way of determining if a stock is overvalued or undervalued is to compare its dividend yield with that of similar companies.

• Safety, growth, and other factors being equal, the stock with the highest dividend and the lowest share price is the best bargain.
• As a further check of value, investors should compare the stock's dividend yield with that of the whole stock market dividend yield.

Rationale for Withholding Dividends

If a company isn't paying dividends it should, like Berkshire Hathaway, be doing something profitable with its earnings.  

It is acceptable to withhold dividends for the following reasons:

• To strengthen the company's working capital
• To increase productive capacity
• To reduce debt.

Graham contended that when corporate management is stingy with dividends or withholds them altogether, it is sometimes for self-serving reasons.  It is easier to keep the cash on hand to bail management out of bad times or bad decisions.  Sometimes the dividend policy is simply a reflection of the tax status of management and large investors - they don't want the addition to their current taxable income.  Consequently, other investors get no income.

Dividends in Jeopardy

Dividends may be put in jeopardy in two ways:

• When a company's earnings per share is less than its dividend per share
• When debt is excessive.

A company's average earnings (over several years) should be sufficient to cover its average dividend.  Though earnings per share can fall below dividend per share from time to time with reserves making up the difference, the condition can persist for only so long.  

A company with substantial earnings rarely becomes insolvent because of bank loans.  But when a company is under pressure, lenders may require a suspension of dividends as a form of financial discipline.