E Growth Trap: Why Is Earnings Growth Not Always A Good Thing?

 

Public companies are enthusiastic about reporting high EPS growth. That is what the market usually cheers about, pushing stock prices higher as we often see post earning reports.  Several studies show that reporting companies could see their shares move on average as much as four times the normal daily average. Theoretically, shortsighted Mr. Market is right since EPS increase/decrease should lead to the ups and downs of the stock price given that P/E ratio would stay the same. However, those long-term-thinking quality-focused investors may want to think twice.

What is really missing in the P/E and EPS is the matter of how much capital would be needed to generate the earning. Many investors should be familiar with the concept around return on capital, such as return on equity, which is one of Warren Buffett’s favorite metrics. The higher the return on equity, the lower the equity capital needed to generate the same amount of earnings to owners.  

Apparently, investors are looking for a high return on capital. But how high is enough? This is all about opportunity cost for the shareholder (i.e., the required rate of return or cost of capital). For example, an investor who has the investment opportunity to generate 10% somewhere else would be happy to see the company s/he invests in has continuous growth with a 30% return on equity and no dividend payment. On the contrary, the same investor would hope for no growth at all and simply get the dividend payment if the company could only deliver 3% ROE. Think of it this way: how is reinvesting at a government bond type of return any better than just paying her/him a dividend for better opportunities somewhere else?

The Importance of ROIC

 

High growth with low ROE means costing a large amount of equity capital to expand businesses and it is usually done at the expense of shareholder value.

In my view, companies with an ROE below 10% (or ROIC below 5%) should always pay out all its earnings back to shareholders as dividends. Only those companies with 20%+ ROE (or 15%+ ROIC) should solely worry about generating more growth.