Company growth

January 21st, 2013

What Warren Buffett looks for in company growth

An investor likes to see a company grow because, buy if profits grow, and so do returns to the investor. The important thing for the investor, pharm 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.

Posted by Julian Livy on January 21st, 2013 | Posted in How Buffett invests |