Key points
- Calculating compounding growth of earnings, like Warren Buffett does, can be effective in finding consistently profitable companies
- Learning Technologies Group and Frontier Developments both boast strong earnings growth
- These firms have also reported significant increases in revenue
As one of the most successful investors of all time, Warren Buffett knows a thing or two about picking stocks. His technique of calculating the compound growth of earnings per share (EPS) can be very helpful for finding exciting growth stocks. I’m looking closely at this metric, then applying it to two FTSE AIM stocks. Let’s take a closer look.
How Warren Buffett uses compound growth
Warren Buffett has long stated that investment growth requires time. This is because the power of compounding — that is, the constant rate of return over a given time period — may only truly be seen over a long period. In essence, calculating compound growth allows me to see which companies are consistently profitable over time.
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The formula for working out compounding growth is: (Vfinal/Vbegin)1/t − 1, where V = value and t = time.
To use the formula, we would take a data set, in our case the EPS figures. The ‘final value’ is the most recent figure in the set. The ‘begin value’ is the oldest figure.
One of Warren Buffett’s biggest holdings is Coca-Cola and we can apply the above formula to understand why he likes this business. Even in the last four calendar years, the EPS displays consistent growth. Its 2021 EPS was ¢2.26 and 2018 was ¢1.51.
We begin by dividing 2.26, the ‘final value’ from 2021, by 1.51, the ‘begin value’ from 2018. This equals 1.49 and we then calculate 1.461/t. The period of time is four years, so 1.461/4 gives us 1.106. This result, minus 1, finally equals 0.106, which is 10.6% in average yearly growth in EPS. In my experience, this formula has been ruthlessly effective for finding the best growth stocks.
2 FTSE AIM stocks that display growth
This process helped me find two growth stocks. The first, Learning Technologies Group (LTG), is a software support services firm. For the 2020 calendar year, EPS was 4.42p, compared to 1.29p in 2016. With the aid of the above formula, I have calculated that the compound annual growth rate of this company’s EPS is 27.9%. This is very appealing to me as potential investor.
Its price-to-earnings (P/E) ratio, that may reveal if a company is under- or over-valued, is 73. This is far higher than a close competitor, Tribal Group, that has a P/E ratio of 28.79. Nonetheless, a recent trading update forecast that revenue for the 2021 calendar year will not be less than £254m. This is a major improvement from 2020, when revenue was just £132.3m.
Another business, Frontier Developments, a video games developer and publisher, has earnings growth of 19.5%. For 2021, this company’s EPS was 55.4p, having increased from 22.7p in 2017. The firm did swing to an interim loss for the six months to 30 November 2021, due to higher costs. Nonetheless, revenue increased 33% to £49.1m on a year-on-year basis.
The technique of calculating compound earnings growth is regularly used by Warren Buffett. While it should be supported with other information, like revenues, it is a good indicator of whether a company is performing for its shareholders or not. Both Learning Technologies Group and Frontier Developments fit the bill and I will be buying shares in both firms now.
