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.

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.

 

  •   12 September 2014
  •      
  •   

 

Leave a Comment:

RELATED ARTICLES

LICs vs ETFs – which perform best?

Why I dislike dividend stocks

Doubling down on dividends

banner

Most viewed in recent weeks

Retirement income expectations hit new highs

Younger Australians think they’ll need $100k a year in retirement - nearly double what current retirees spend. Expectations are rising fast, but are they realistic or just another case of lifestyle inflation?

Four best-ever charts for every adviser and investor

In any year since 1875, if you'd invested in the ASX, turned away and come back eight years later, your average return would be 120% with no negative periods. It's just one of the must-have stats that all investors should know.

Why super returns may be heading lower

Five mega trends point to risks of a more inflation prone and lower growth environment. This, along with rich market valuations, should constrain medium term superannuation returns to around 5% per annum.

Preparing for aged care

Whether for yourself or a family member, it’s never too early to start thinking about aged care. This looks at the best ways to plan ahead, as well as the changes coming to aged care from November 1 this year.

Our experts on Jim Chalmers' super tax backdown

Labor has caved to pressure on key parts of the Division 296 tax, though also added some important nuances. Here are six experts’ views on the changes and what they mean for you.        

Why I dislike dividend stocks

If you need income then buying dividend stocks makes perfect sense. But if you don’t then it makes little sense because it’s likely to limit building real wealth. Here’s what you should do instead.

Latest Updates

Investment strategies

LICs vs ETFs – which perform best?

With investor sentiment shifting and ETFs surging ahead, we pit Australia’s biggest LICs against their ETF rivals to see which delivers better returns over the short and long term. The results are revealing.

Retirement

The growing debt burden of retiring Australians

More Australians are retiring with larger mortgages and less super. This paper explores how unlocking housing wealth can help ease the nation’s growing retirement cashflow crunch.

The ASX is full of broken blue chips

Investing in the ASX 20 or 200 requires vigilance. Blue chips aren’t immune to failure, and the old belief that you can simply hold them forever is outdated. 

Shares

Buying Guzman Y Gomez, and not just for the burritos

Adding high-quality compounders at attractive valuations is difficult in an efficient market. However, during the volatile FY25 reporting season, an opportunity arose to increase a position in Mexican fast-food chain GYG.

Investment strategies

Factor investing and how to use ETFs to your advantage

Factor-based ETFs are bridging the gap between active and passive investing, giving investors low-cost access to proven drivers of long-term returns such as quality, value, momentum and dividend yield. 

Strategy

Engineers vs lawyers: the US-China divide that will shape this century

In Breakneck, Dan Wang contrasts China’s “engineering state” with America’s “lawyerly society,” showing how these mindsets drive innovation, dysfunction, and reshape global power amid rising rivalry. 

Retirement

18 rules for ageing well

The rules to age successfully include, 'the unexamined life lasts longer', 'change no more than one-eighth of your life at a time', 'nobody is thinking about you', and 'pursue virtue but don’t sweat it'.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
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. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. 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.