When it comes to investing, the first thing I consider about a company is dividend growth. I prefer to invest in companies that have at least a 5 year history of annually increasing their dividend payment to shareholders. For me, a company that is able to grow it’s dividend over a period of time is usually a successful company. Also, management is showing their faith in the future performance of a company by committing to pay out a higher and higher dividend to owners.
While I believe dividend growth signals great companies, there is another growth metric I believe to be the most important when considering an investment. The number one thing I look for in investments and do not want to compromise when deciding which companies deserve a spot amongst my portfolio is earnings per share (EPS) growth.
Earnings Per Share Growth is the Driver of Wealth
As a shareholder of a company, the most important bottom line number for me is the earnings per share (EPS). When I buy stock, I am an owner of that company. Each share I own is worth a small fraction of the company. The total amount of the company I own depends on how many shares I own.
The earnings per share amount is simply the total net profits of a company dividend by the number of shares outstanding. To calculate my portion of the earnings, I can take the EPS amount multiplied by the number of shares I own. This is technically my portion of the profits of the company. Now management of the company will decide what to do with those profits. They can reinvest back into the company or pay out profits to shareholders in the form of dividends.
As an investor, I want my company to grow in value over time. The way for a company to achieve this is by growing their earnings per share.
For example, lets say I purchase a company with EPS of $1.00. Let’s say I pay a price of 10 times earnings or $10 per share. Over time I expect management to do a good job growing the company. If over the course of a few years they are able to double the amount of EPS I am earning to $2.00 and the market is still pricing the company at 10 times earnings, then my shares will be worth $20 each.
So the first way EPS growth creates wealth is because as EPS grows the value of the shares I own grow. This is why I look to invest in companies that have proven they can consistently grow earnings over time. By growing their EPS, the company is making each individual share worth more.
As a dividend growth investor, I like to receive part of my portion of the company’s earnings in the form of a dividend payment every quarter. Currently I am reinvesting my dividends in order to take advantage of compounding to grow my wealth.
Earnings per share growth is very important to dividend growth investors. Looking at the example from above. If the company I purchased that was earning $1.00 per share is unable to grow their earnings over time, do you think they will be able to pay me an increasing dividend over time?
Companies cannot pay out more than they earn over long periods of time. At some point a dividend that is higher than EPS will become unsustainable.
However, if that same company is able to grow earnings per share, they can also grow my dividend payment right along with it. Therefore, EPS growth is the lifeblood to dividend growth. Without growth in EPS, there cannot be sustainable growth in the dividend.
This is why it is vitally important to only invest in companies that have a proven history of EPS growth. Of course past performance does not guarantee future results. But I’ll take my chances with a proven performer any day compared to a company that hasn’t shown the ability to grow earnings over time.
The Two Things I’m Looking for in EPS
Consistently trending upwards. When I am looking at the 10 and 15 year financial data of a company, I like to see companies that generally have a growing trend in EPS. I look for companies who have demonstrated the ability to grow thier bottom line for thier investors year after year. It’s alright to have a down year or two every once in awhile. In fact a down year can provide good buying opportunities for investors as long as they are confident the company will turn things around shortly. However, I want to make sure the growth trend is generally up and consistent, not sporadic.
A decent earnings per share growth rate. When evaluating a company I always calculate the 10 year compounded annual growth rate of the EPS. The higher the growth rate the better. Generally I look for a growth rate of at least 5% on average. This earnings per share growth is the driver of all future returns from a company.
Two Examples of Dividend Growth Companies and EPS Growth
1.) Diebold Inc (DBD) is one of the longest dividend growers having raised their dividend payment annually for 60 years in a row. This might lead one to believe this is a great company for dividend growth investors to own. However, a look at their EPS data over the past 10 years paints a very different picture.
As you can see, the EPS has been very sporadic for Diebold over the past decade. There have been some good years followed by some very bad years. In fact, you can see that had you purchased shares back in 2003, your shares are earning significantly less now almost 10 years later. The performance of Diebold for investors over the past decade has not been good. Earlier this year the CEO of Diebold was pushed out due to the poor performance of the company. This is not the kind of company dividend growth investors want to be an owner of.
2.) Walgreen’s (WAG) is a retail pharmacy that has been increasing dividend payments to investors annually for the past 37 years. This is another company with a long history of dividend growth. Let’s take a look at their past 10 years worth of EPS data.
Looking over that chart, we can see that Walgreen’s has done a good job growing earnings over the past decade. In fact, EPS have more than doubled! Now it hasn’t been the smoothest of rides. Like most companies, WAG had a couple down years during the recession in 2009 and 2010. However, they recovered nicely. More recently, WAG had a dispute with prescriptions benefit manager Express Scripts. This weighed on the 2012 EPS data. This dispute has since been resolved and investors expect Walgreen’s to recover over time. Mostly, Walgreen’s EPS trend is upward and there is good growth in the data. This is the kind of company dividend growth investors should want to own.
On a side note, events such as the recession and the Express Scripts conflict can give investors great opportunities to pick up shares of wonderful companies at discounted prices. As long as an investor is confident that the company can recover and improve performance going forward, they should feel good getting a discount on the shares of great companies. In fact, I took advantage of the Express Scripts conflict and purchased shares in Walgreen’s at a great valuation. The company has since recovered, and my WAG investment has so far been my best performer.
In conclusion, the EPS growth is the most important driving force behind the creation of wealth. EPS growth will allow companies to continue growing our important dividends over time. Also the EPS growth will continue to push up the value of the shares we own. Look for companies that are growing their earnings in a consistent up trend. These types of companies should turn out to be good long term investments providing the foundation to a solid financial future.
What do you think? Is EPS growth that important? Are you willing to compromise when it comes to past EPS performance from companies you look to invest in? Please share your thoughts in the comments below!
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