5 Ways Companies Can Grow Earnings
Growth. It is what "Mr. Market" loves.
What else to explain how Amazon (AMZN) can trade at traditionally nose-bleed valuations for over 15 years? Or how Netflix (NFLX) can be a market darling at an unheard of P/E ratio of 238 times earnings! Or how Tesla (TSLA), a company with tremendous financial risk, a gauntlet of competition, and unprofitable operations and outlook, can continue to trade at 8.4 times sales?
Not all growth comes at such a price, though. Many rapidly growing companies are actually priced *under* market averages. These are one group to look for.
But also, growth isn't always immediately obvious. Today, I want to walk over 5 different ways that companies can grow earnings. Several of them are obvious, a few of them are sometimes overlooked, but they all can be utilized to grow the all important earnings per share number. And growing earnings per share, ultimately, is what grows the stock price.
#1: Grow Revenue
The only way to truly "grow" a company is to grow its revenue. Precisely, a company has to grow its revenue profitably.
The really huge gains from Magic Formula® and other value investing techniques come from identifying undervalued stocks that can continue to grow revenues at rates exceeding expectations, then riding those stocks for years.
There are several MF stocks that are growing by increasing revenues rapidly. Perhaps the best two examples are Apple (AAPL) and Gilead (GILD) - two stocks valued far below the market averages that are growing sales far ABOVE the average company.
#2: Grow Profit Margins
Even with flat revenue contribution, a company can grow its earnings by becoming more efficient and delivering better profit margins.
This is what companies are trying to do when you hear the term "restructuring" and my favorite, "right-sizing". Many larger firms with many lines of business will also seek to divest lower margin (or money losing) businesses to raise the corporate average.
A really good MF example of growing revenues through profit margins is Brocade (BRCD). In the past 4 years, Brocade's revenue is almost exactly the same, but its profits have increased almost 163%! Over that period, Brocade has pruned its product lines and substantially cut back on marketing costs, driving operating margins up from 8.9% in 2011 to over 22% today.
#3: Share Buybacks
Buying back shares is often "pooh-poohed" as cheating to grow earnings per share, but the truth is that, done right, share buybacks are an excellent way to deliver steady returns.
Share buybacks are best utilized by companies with excellent, reliable cash flows, at share prices that are at or under a reasonable fair value estimation. Share count can be reduced at a steady, 2-4% rate annually, complimenting modest revenue and margin growth to create nice overall shareholder returns. Altria (MO) was the best performing S&P 500 stock over a long 50 year period not due to heady revenue growth or even widely expanding margins, but because it bought back shares that allowed it to raise its dividend year after year.
#4: Lower Tax Rates
Now we get into the more obscure, non-operating ways that companies grow earnings per share.
Maybe the most gamed line on the income statement is the tax rate. Most companies that do business in just the U.S. pay a 30-35% base tax rate. International companies usually pay less. Management of firms with overseas business go to great lengths to avoid re-patriating cash and even moving cash offshore to reduce taxes. And then there are "net operating losses" (NOLs) - past unprofitable years that can be banked to reduce tax rates in later, profitable ones. Settlement of tax disputes with the IRS and other factors can affect tax rates as well.
While somewhat spurious, and not a typical growth focus, tax rates can have an enormous effect on earnings, as each percentage change in the tax rate drops right to earnings per share. Oracle (ORCL) is a good example of a long-term, disciplined approach to reducing taxes, as it lowered its effective tax rate from nearly 30% in 2008 steadily down to 20% in 2014, improving shareholder earnings by 10% by the end of that stretch.
#5: Improved Financing
For too many firms in the market, debt interest service is a major cost that eats a large portion of shareholder earnings. So, naturally, one way to increase earnings per share is to decrease interest costs, all things equal.
There are a couple ways management can accomplish this. For one, they can pay off portions of their debt. Secondly, they can refinance some of their higher rate bonds or bank loans at lower rates. Both of these lead to lower interest costs.
One example here would be Sanderson Farms (SAFM), which has used favorable chicken and feed prices to pay off what was almost $30 million in debt a few years ago, reducing interest expense from $9.2 million to $2.6 million, contributing about 3% to earnings growth.
Improving interest costs is an "at-the-margins" way to boost earnings, but it is a contributor.
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