Why EPS Growth Rate Matters

What are EPS and EPS Growth Rate?

EPS (Earnings Per Share) is calculated by dividing a company's net income by its number of outstanding shares. If net income is $100 billion and the number of shares is 100 million, then EPS is $1,000. It's a metric that shows how much profit, on an accounting basis, is attributable to each share held by a shareholder.

The EPS growth rate is the percentage by which EPS has increased over a certain period. If last year's EPS was $1,000 and this year's is $1,200, the growth rate is ($1,200 - $1,000) / $1,000 = 20%. When looking at trends over several years, converting to a Compound Annual Growth Rate (CAGR) helps avoid being swayed by temporary fluctuations in a single year.

This article is educational material explaining how to interpret metrics, not an investment recommendation. The same principles apply equally to KOSPI stocks in Korea and S&P500 stocks in the United States.

Stock Prices Ultimately Follow Earnings

In its simplest form, a stock price can be broken down into 'EPS multiplied by P/E ratio'. For example, if EPS is $5,000 and the market assigns a P/E ratio of 15x, the stock price would be $75,000. While the P/E ratio fluctuates based on investor expectations and sentiment, EPS is the result of a company's actual earnings.

In the short term, the P/E ratio can swing significantly, causing stock prices to fluctuate. However, over a 5-year or 10-year horizon, the range of P/E ratio fluctuations is limited. Companies whose EPS has consistently doubled or tripled tend to see their stock prices trend upwards, reflecting that earnings growth.

Conversely, companies with stagnant or declining EPS find it difficult to sustain stock price gains, even if they temporarily rise on optimism. The reason for looking at EPS growth rate is that the foundation of long-term returns is earnings growth.

How to Interpret Growth Rates

You cannot determine good or bad solely by the absolute number. Even 5% annual growth might be robust for a stable consumer staples company, but disappointing for an overvalued growth stock. Growth rates should always be considered in conjunction with the characteristics of the industry the company belongs to and market expectations.

The quality of growth is also important. EPS growth accompanied by rising revenue signals that the business is genuinely expanding. In contrast, EPS growth achieved through cost cutting or share buybacks while revenue remains flat may lack sustainability. It's essential to develop the habit of checking the source of growth on the income statement.

PEG is a metric that links growth rate and valuation. It's calculated by dividing the P/E ratio by the EPS growth rate. For a company with a P/E ratio of 30x and a growth rate of 30%, the PEG would be 1.0. This metric quantifies the intuition that a higher growth rate makes the same P/E ratio less burdensome.

Practical Application

A single year's EPS can easily be swayed by one-time factors, so it's important to look at the trend over at least 3 to 5 years. If one-time gains, such as profits from real estate sales or reversals of litigation provisions, are included, that year's EPS can be inflated. The key is whether earnings are consistently growing from core operations.

In addition to past performance, also consider future EPS estimates from the market. The forward EPS growth rate, calculated from the average of estimates by multiple brokerage firms (consensus), reflects future expectations, but it's crucial to acknowledge the limitation that these are estimates and can be inaccurate.

When a company's quarterly earnings report is higher or lower than market expectations, the stock price often reacts significantly—this is an earnings surprise. Tracking the EPS growth trend alongside the discrepancy between actual reported figures and expectations can help you understand the gap between anticipation and reality.

Common Pitfalls and Limitations

Since EPS is calculated by dividing by the number of outstanding shares, it is affected by changes in the denominator. If a company buys back and retires its own shares, EPS will rise even if net income remains the same. If the number of shares increases due to an equity issuance, EPS will be diluted even if earnings are the same. This is why it's crucial to check for changes in share count when looking at growth rates.

Beware of the base effect. Immediately after a company turns profitable from a loss, the growth rate might appear to be several hundred percent. However, this is because the comparison base was very low, not necessarily because the business exploded to that extent. Abnormally high growth rates should be interpreted after checking the denominator.

EPS represents accounting profit and may differ from actual cash flow. Since accounting methods allow for some adjustment of profits, cross-referencing with metrics like free cash flow (FCF) or operating margin can provide a clearer picture.

Key Checkpoints

In summary, while EPS growth rate is a fundamental driver of long-term stock price appreciation, it should not be read as a single number. You must also consider whether the growth is accompanied by revenue growth, if it's free from non-recurring gains or changes in share count, and if it's at an appropriate level given the industry and valuation context.

Here are the items to check: Is the 3-5 year trend upward? Is it supported by revenue growth? Is it inflated by changes in share count? Is the P/E ratio relative to growth rate (PEG) reasonable? Do cash flow metrics align with the direction of EPS growth? Regularly checking these five points will allow you to utilize the EPS growth rate metric much more comprehensively.