If history is anything to go by, growth stocks can generate spectacular returns. But it’s not just about how much earnings per share (EPS) are going to increase in future.
In the 1977 letter to Berkshire Hathaway shareholders, Warren Buffett identified a key metric for investors to pay attention to. And it shows there’s more to growth than a rising EPS.
Earnings per share
On the subject of EPS, Buffett said the following:
“Most companies define ‘record’ earnings as a new high in earnings per share… [But] even a totally dormant savings account will produce steadily rising interest earnings each year because of compounding.”
A firm that retains part if its profits (rather than using them for dividends) should be able to generate EPS growth. It can do this by keeping the income in cash and earning interest.
Investors, however, should expect companies to do better than just earning interest on cash. With this in mind, Buffett proposed a different metric for assessing growth.
Return on equity
Rather than focusing solely on earnings, Buffett suggested looking at return on equity (ROE):
“Except for special cases (for example, companies with unusually high debt-equity ratios or those with important assets carried at unrealistic balance sheet values), we believe a more appropriate measure of managerial economic performance to be return on equity capital.”
When companies retain earnings (rather than using them for dividends) it increases their equity base. And the company’s ROE measures its net income against the value of its equity.
This helps distinguish firms that grow just by retaining cash from ones that are investing at good rates of return. And it’s the second type that make the best great growth stocks.
An example
I think FTSE 100 stock Halma (LSE:HLMA) is a great illustration of Buffett’s point. Since 2020, the company has retained around 70% of its net income and reinvested it to generate growth.
During that time, the firm’s EPS have increased by around 45%. But this isn’t just the result of retaining cash – it has been using the cash well and earning strong returns on its investments.
| Year | Return on Equity |
|---|---|
| 2020 | 17.4% |
| 2021 | 17.7% |
| 2022 | 19.0% |
| 2023 | 15.6% |
| 2024 | 16.1% |
The firm has maintained an ROE above 15%, which suggests it has managed to invest its retained cash at good rates of return. In Halma’s case, this has often involved acquisitions.
Investors will need to think about the risk of the company’s opportunities to keep doing this being more limited in the future. But I think its record so far has been very impressive.
Growth investing
Businesses in growth mode generally look to invest their profits into opportunities that can boost future earnings. But not all of them are the same.
A company that needs £100 to increase its earnings by £1 is different to one that can do this with £10 while returning £90 to shareholders. And this is what the ROE helps investors assess.
Halma’s one of a few UK growth stocks that shapes up well on this front. It looks expensive to me at the moment, but I think it’s definitely one to keep an eye on in future.
