Earnings Per Share Growth – real growth or a return to the norm?
Sometimes it can be easy to get carried away with the growth in the earnings per share (EPS) for a company; particularly when that growth is just a return to the normal levels – typically after a year of depressed earnings. There is a lot of really good reading material about the subject of looking at “Peak” Earnings; a quick google of Hussman Funds Weekly Market Commentary or James Montier of GMO will probably provide you with some excellent articles on the subject.
Basically the idea is to iron out the ups and downs of a firms earnings using the maximum EPS over a period to to calculate “Peak to Peak” EPS growth – the best way to show you is an example using what I consider a really good organisation A.G. Barr (BAG.L) – Looking at the EPS trend of the firm you can see that with the exception of 2012 there has been consistent growth – the 10 year annualised EPS growth is around 11% p.a.
However if you had looked in 2013 and seen that earnings had shot up by 192% then at first glance you would undoubtedly have been impressed; this was well above the average of 11% and if growth like that continues surely this is a share I should be buying? Well its never quite that simple…….into 2014 the share price would reach £6.72 before ultimately falling back to its current price of £5.13.
Now there are any number of reasons that could be attributed to causing the declining share price – not least the overall market conditions – but looking at the Peak PE over the 2012-2015 period would have told us a lot, and also made you question if it was the best time to be buying this share.
Here is how we start……
Look back at peak to peak earnings growth over a prolonged period
- AG Barr had an EPS high of 8.48 in 2001 before declining in 2002 and then growing without interruption until 2011 when it reach a new peak of 19.89
- This means peak to peak earnings growth between 2001 and 2011 of 8.90% p.a. (8.48 growing to 19.89 over 10 years)
- After a decline in 2012 growth in EPS returned and with no further set backs since we can use 2015 and 28.59 as the next peak
- This means peak to peak earnings growth between 2011 and 2015 of 9.50% p.a.
- This gives us a fairly clear indication of the normal earnings trend – a simple average of 9.20% p.a. (8.9 + 9.2 / 2)
- Using this normal growth of 9.20% and applying year on year to the first peak EPS of 8.48 in 2001 allows a graph of the trend to be created (in red below)
- Adding in the actual normalised EPS (green) means we can then see is the growth in earnings something new or simply a reversion to trend
From this we can clearly see that the EPS growth of 2013 was a reversion to the norm and not something new; the EPS was simply recovering back towards its normal growth levels and should not have been seen as something that was likely to continue indefinitely and drive the share price higher and higher.
Peak 5 Year PE
The Peak EPS can also be used to create a Peak PE ratio for the share; my preference is for a rolling 5 year Peak PE – this means I calculate the PE Ratio based on the highest EPS in the last 5 years; the results for AG Barr are graphed below in green whilst the red graph shows the annualised share price return over the subsequent five years.
As you will see the Peak PE is a pretty accurate reached a new high in the 2013-2015 period and that from 2000 onward higher Peak PE ratios are associated with lower future returns. The decline in share price since 2015 may now be pushing potential returns back up and starting to present a better point to start considering investing in a firm that has many of the attributes that I look for.
The point of looking at all these factors is not to create a perfect model to predict returns, but rather to provoke questions that investors should be asking themselves when they are thinking about buying a share – using these ideas within a framework will just make that buy or sell decision more considered and hopefully a little easier.