When looking for stocks to buy, there’s one thing I that think is more important than anything else at the moment. And that something is growth.
A company’s ability to increase its earnings per share (EPS) is something investors should always consider. But I believe it’s the most important thing for investors to think about right now.
Share prices
There are two main reasons why a company’s share price might go up. One is the business making more money and the other is investors being willing to pay a higher multiple for its earnings.
Take Apple as an example. Over the last five years, the company’s share price has increased by 247%.
One reason for this is the company has grown it’s earnings. Apple’s earnings have gone from $2.98 per share in 2018 to $6.11 now.
That accounts for around 105% of the increase, though. The rest comes from investors being willing to pay more for the company’s earnings.
Five years ago, the stock traded at a price-to-earnings (P/E) ratio of around 17. Today, that ratio is closer to 30.
In other words, the Apple share price has benefitted from a double tailwind of the business growing while investors have been willing to pay higher multiples for the company’s earnings. But I don’t think this is sustainable.
Interest rates
Over the last five years, interest rates have been low. This has meant investors haven’t been able to get a decent return from cash and bonds.
Consequently, they have been willing to pay higher multiples for shares, causing prices to rise. But the outlook for the next five years is quite different to the last five years.
Interest rates have been rising in both the US and the UK. And the steady rise in P/E ratios has already begun to slow as a result.
Since rates started rising at the beginning of 2022, Apple shares have gone from trading at a 32 P/E ratio to 29. Furthermore, both the Bank of England and the US Federal Reserve are signalling that rates are going to remain high.
As a result, I don’t think multiples are going to expand in the future the way they have done in the past. So the main force moving share prices higher over the next few years is going to have be earnings growth.
I’m therefore looking to buy shares in companies that can make more money in future than they do today. Looking ahead, the capacity for growth is going to be the most important thing, in my view.
Buying stocks
There are various ways for a company to increase its profits. And different businesses will look to achieve this in different ways.
Some, like Diploma, are going to aim to grow their revenues. Higher sales should, other things being equal, translate to higher EPS.
Others, such as Rightmove, are likely to use share buybacks to reduce their outstanding share count. With fewer shares outstanding, EPS should increase even if the company’s overall profits stay steady.
I’m not concerned about how any particular business makes it happen. But I’m convinced that potential earnings growth is the most important thing for investors looking for stocks to buy right now.
