Should you buy stocks based on earnings growth?

Growth in earnings is considered one of the most important drivers behind every stock price appreciation.

Stock prices tend to go up when earnings exceed expectations as market anticipates higher growth in the future, but when results are disappointing, share prices tend to fall as market takes it as warning sign of lower earnings ahead.

Market expectations about earnings growth play a key role in driving stock performance. Very often, investors pay premium over the earnings growth potential of a stock.

In my recent column “How to value stock growth expectations” several weeks ago, I explained that the value of speculative growth accounts for about 54.8 percent, on average, in the share prices of all listed companies in the PSE.

This means that more than half of market value of stocks are driven by growth expectations so that the more credible the earnings story of a stock, the higher its share price valuation.

But in a market environment where inflation is rising to a multiyear high and the peso-dollar exchange rates falling to an all-time low, paying a premium for a stock’s earnings potential may be risky.

This is because earnings growth becomes problematic when there is high uncertainty. Investors tend to pay premium for growth stocks but how do you avoid paying too much for earnings?

One basic principle of investing states that an investment can only add value if it earns more than its hurdle rate. Following this principle, a company must generate return on equity above its opportunity cost in order to create intrinsic value into its share price.

If a company is just earning enough to cover its minimum required return, no value is created that will merit premium.

On the other hand, if a company is earning below its hurdle rate, its earnings will still grow but overall returns on equity will decline and eventually drag its share price lower to reflect the discount.

To illustrate, let’s assume that San Miguel Corp. (SMC) has an opportunity to reinvest P7.33 a share or 84 percent of its trailing earnings per share of P8.72.

SMC has historical return on equity (ROE) of 9.4 percent that is greater than its hurdle rate estimated at 8.4 percent. The investment of P7.33 a share will result to an annual earnings of P0.69, which represents ROE of 9.4 percent.

Because SMC has lower hurdle rate, the project will generate a positive net present value (NPV) of P0.88 per share.

If SMC continues to reinvest every year as its earnings grow assuming the same ROE and hurdle rate, its future projects will generate growing positive NPVs.

Imagine if we account for the present value of all its NPVs in the future, the resulting value shall form the growth premium in the share price.

SMC has about 41 percent of growth value in its share price, which is comparatively lower than market median of 54.8 percent. With the company’s aggressive expansion plans, does the stock deserve higher growth premium?

While growth value accounts for more than half of share prices in PSE, not all listed stocks have ROEs that are greater than their hurdle rates. In fact, only 38 percent of all stocks in the market can generate positive NPVs.

Among the 30 blue chip stocks in the PSE index, there are only 11 that generate positive residual earnings while others earn below their hurdle rates.

The stock market, in general, rewards stocks that demonstrate growth in earnings, especially in the short-term.

The higher the expected earnings, the more undervalued the stock price should be as indicated by everyone’s favorite tool, the Price-to-Earnings (P/E) ratio.

But earnings growth, as shown in this exercise, is not enough to warrant a premium. Overtime, share prices will fall as a result of declining ROEs.

A company may be expanding and reporting fantastic growth but if the cost of equity to finance its growth is higher than its returns, then no value is added. Actually, shareholder value is destroyed.

Investing in stocks should not be based on earnings growth alone. It is the growth of residual earnings that should drive long-term stock price performance.