Sep 7, 2009|
Will this company's earnings grow year after year?
This is a question that comes to the mind of every long term investor. We would all like to see the company in which we have invested into for the long term grow its earnings year after year, every year. But have you ever sat down and contemplated on what exactly is it that makes this earnings growth possible? Or for that matter, what are the different factors whose presence is necessary to enable a company to grow its earnings?
What makes asking these questions particularly interesting is that once you know what these factors are, you can look at your each of your holdings more deftly to see in which of the company's cases are these factors (that enable earnings growth) present, and conversely, in which of them are they absent.
Earnings growth, in its most basic form, is made possible by either
- Being able to fetch the same rate of return on investing additional capital/funds in the business
- Being able to increase the rate of return achieved by the same level of resources/assets invested in the business
- Or, doing both of the above at the same time
And so, in light of this basic nature of earnings growth in a company as stated above, the questions one can ask while trying to figure out if a company can grow its earnings over a number of years become a little clearer. Infact, they also help throw some light on whether the earnings will continue to grow at a fast clip.
Some of the most obvious ones include:
- What are the macro economic conditions required for the company to be able to continue investing more capital in the business and achieve high rates of return on the same?
- Are such conditions present currently?
- If yes, then how long can they last for at a stretch?
- If no, then is it probable that they will return some time in the near future? Infact, in some cases it is almost inevitable that they return, though it may seem like exactly the opposite at the time.
- Competition has a constant downward pressure on the returns on invested capital in a business. Thus if returns on capital invested in the business are high, can the competitive scenario erode them in future?
- Even if demand for a certain product/service that a company is selling is slated to be exceptionally high, is it probable that the supply of that product/service will grow even faster, thus taking away from the returns that the company earlier hoped to achieve? (Usually happens due to excessive competition attracted by a very lucrative market/business). In other words, are high returns attracting a lot of capacity addition in the industry which will force prices and margins downwards?
- What is the nature of the product and will very high demand for it prove be a temporary phenomenon? (high demand for air travel during times of boom)
- When viewed historically, is the current demand abnormally high or abnormally low?
Attempting to answer the above questions can help one tremendously in getting clarity over sustainability of earnings growth. It will also give indication of when the growth will begin to taper off. Besides doing a good job of helping one choose a company to invest in, such qualitative analysis can help one avoid overpaying to buy into fads wherein the markets become euphoric about some company or sector, only to later realise the illusion of unending growth.
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