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.