Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 79

Pay attention to how growth is financed

With iron ore slumping to five-year lows and Peter Reith suggesting Australia is headed for an ‘inevitable’ recession, the subject of growth should be a major focus for investors. Our previous article on understanding growth showed some tools available to companies to manipulate revenue growth. In this article, we look at understanding earnings per share growth and its funding.

If the point of investing is to forego expenditure today with the objective of improving purchasing power in the future, then this goal is enhanced by the pursuit of both value and growth. Value cannot be estimated in the absence of an estimate for growth. ‘Growth’ and ‘value’ must be two sides of the same coin.

Capital required to generate growth

Analysts and investors tend to focus purely on the growth that flows out of a company as measured by earnings and dividends. You will also find references to earnings per share growth in corporate communications about executive remuneration and mergers and acquisitions. Companies will explain that a proposed acquisition is earnings per share ‘accretive’ without much discussion about the impact of funding choices on investor’s long-term returns.

Focusing only on earnings growth can lead investors astray. Take the example of ABC Learning Centres. For years, the company attracted a legion of fans as earnings swelled from $12 million in 2003 to $143 million in 2007. Focusing only on the earnings growth however ignored the funding that was employed to drive it and ultimately entrapped those investors enamoured only with headline earnings growth numbers.

In my experience, business owners tend to focus on the capital required to generate a dollar of earnings much more than equity analysts covering stocks. Indeed, how many dollars are required to fund the growth in earnings is arguably more important than the dollars of earnings themselves.

Suppose $1 million is invested in a manufacturing business that produces a cash profit after tax of $400,000, representing a 40% return. Visions of grandeur cause the owner to expand the operations geographically and after investing another $1 million the following year in a second factory, profits grow 25% to $500,000.

A 25% growth in after-tax earnings is nothing to sneeze at. Indeed, such growth rates are pursued vigorously by professional investors.

However, thinking beyond the earnings growth reveals what a poor investment the second factory is. While earnings have grown, more equity has been contributed to the business to achieve that growth. Invest more funds in a bank account and interest earnings will rise and the only property, plant and equipment (PP&E) required is a rocking chair.

The second factory required an additional investment of $1 million and despite this 100% increase in equity, earnings grew only 25%. Putting aside issues relating to ramp up, the second factory has returned just 10% and that presumes all the growth came from the new factory, not from the older facility.

Not all growth is good

There is good growth and there is bad growth. Focusing only on the earnings cannot differentiate between the two. Growth is only good when each dollar used to finance the growth creates more than a dollar of long-term market value.

RM Table1 120914

RM Table1 120914

Table 1 shows a company whose shares are trading on a price earnings ratio of ten times. In Year 1 when the company earned a profit of $50,000, the stock market was willing to pay ten times that profit, or $500,000, to buy the entire company. The company begins Year 1 with $1 million of equity on its balance sheet, and in the first year, it generates a 5% return on that equity (or $50,000). Management decides that they need that money to 'grow' the business and so decide not to pay any dividends. That decision will cost shareholders dearly.

By keeping the profits, the equity on the balance sheet grows from $1 million at the start of the year to $1.05 million at the end. In the second year, the company again earns 5% on the new, larger equity balance, giving a profit of $52,500.

So on the surface things look rosy. The company is growing. The equity has grown, the profits have grown and management is drafting an annual report that reflects their satisfaction. But management has, perhaps unwittingly, dudded shareholders.

Shareholder returns are made up of dividends and capital gains. If a dollar is earned but not received as a dividend, it should be a capital gain. If not, it has been lost and management may be to blame. Every dollar that a company retains by not paying a dividend should be turned into at least a dollar of long term market value through capital gains.

The company in Table 1 has not achieved this, and although the company appears to have grown, shareholders have lost money. How? The company ‘retained’ all of the $50,000 of the profits it earned in Year 1. The shareholders received a gain of only $25,000. The company failed to turn each dollar of retained profits into a dollar of market value. If this were to continue, investors should insist that the company stop growing and return all profits as dividends and if that is not possible, the company should be wound up or sold.

The characteristic to search for, and avoid, is declining returns on incremental equity. This is precisely what happened to ABC Learning Centres and even an investor without a forensic accounting background could have spotted it.

Today, we see this at a range of businesses. Over the last decade, Virgin and Qantas have both seen declining returns on incremental equity. Equity contributed by shareholder owners of AMP has increased from $5 billion in 2010 to $9.7 billion in 2013 and yet profits have declined from a reported $775 million to $672 million. Over at Brambles, equity contributed by owners has risen from $1.4 billion in 2005 to $6.4 billion in 2014, but reported profits have grown only from $528 million to $619 million. At Newcrest, ten years ago the company earned $130 million on $802 million of equity. By 2014, shareholders have contributed $13 billion and despite this altruism the company has managed to earn just $315 million.

Ben Graham’s observation that the market is a weighing machine in the long-run is timeless. The share prices of all of the above examples have produced uninspiring and even some negative returns over a period of ten years.

Not all growth is good but you will do just fine as an investor by focusing on those businesses whose earnings march upward over the years at a faster rate than the rate of increase in the capital used to finance that growth.

Roger Montgomery is the Chief Investment Officer at The Montgomery Fund.


Leave a Comment:



Dividends: more is less, less is more

Chasing dividends often overlooks growth

Take no income from the best companies


Most viewed in recent weeks

A tonic for turbulent times: my nine tips for investing

Investing is often portrayed as unapproachably complex. Can it be distilled into nine tips? An economist with 35 years of experience through numerous market cycles and events has given it a shot.

Rival standard for savings and incomes in retirement

A new standard argues the majority of Australians will never achieve the ASFA 'comfortable' level of retirement savings and it amounts to 'fearmongering' by vested interests. If comfortable is aspirational, so be it.

Dalio v Marks is common sense v uncommon sense

Billionaire fund manager standoff: Ray Dalio thinks investing is common sense and markets are simple, while Howard Marks says complex and convoluted 'second-level' thinking is needed for superior returns.

Welcome to Firstlinks Edition 467

Fund manager reports for last financial year are drifting into client mailboxes, and many of the results are disappointing. With some funds giving back their 2021 gains, why did they not reduce their exposure to hot stocks when faced with rising inflation and rates?

  • 21 July 2022

Welcome to Firstlinks Edition 466 with weekend update

Heard the word, cakeism? As in, 'having your cake and eating it too'. The Reserve Bank wants to simultaneously fight inflation by taking away spending power, while not driving the economy into a recession. If you want to help, stop buying stuff.

  • 14 July 2022

Welcome to Firstlinks Edition 465 with weekend update

Many thanks for the thousands of revealing comments in our survey on retirement experiences. We discuss the full results. And with the ASX200 down 10%, the US S&P500 off 20% and bond prices tanking, each investor faces the new financial year deciding whether to sit, sell or invest more.

  • 7 July 2022

Latest Updates

Financial planning

Five charts show predicaments facing financial advice

The number of financial advisers in Australia has almost halved at a time of greater need than ever. What has happened to the industry and its clients as yet another Quality of Advice Review takes place?


House price doomsayers: Could housing prices really fall by 20%?

Why do house prices move in an up-and-flat pattern rather than up-and-down like shares? When house prices start to fall, supply reduces to create a new equilibrium, rather than needing even more price reductions.

Latest from Morningstar

Why I’m not ready for an SMSF

SMSFs are increasing in popularity among younger investors, drawn by the investment control and fixed costs. But until a sufficient balance is achieved, it may be better to stay with a large fund.

Investment strategies

Six ways to take a ‘private equity’ approach in listed markets

By taking a private equity approach to investing in the public equity markets in this difficult market, investors can harness the 'best of both worlds' and still make superior returns over the long term.

Investment strategies

How to avoid being a bad investor

It's tough to become the 'best' investor in the world, but we can certainly avoid being the 'worst'. Here are graphical examples of some long-term principles to adopt, including the difficulty of timing the market.

Financial planning

The case for closing the financial gender gap

While the gender pay gap is slowly improving in the workplace, ATO data shows Australian men aged 55-59 average $50,000 more in super than women of the same age. Financial advisers have a role to play.


Three opportunities in property in Australia and APAC

Rising interest rates and occupancy threats have reduced the share prices of many property companies and trusts, but the selling underestimates the strong pockets of demand and robust earnings from good tenants.



© 2022 Morningstar, Inc. All rights reserved.

The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.