Past earnings are often a good indicator of future earnings, which is why analysts use earning histories as a valuation tool. This valuation method works best with what Peter Lynch calls the "stalwarts" -- large companies that still have growth potential. With earnings histories of ten years or more, the stalwarts have experienced complete economic cycles of contraction and expansion.
In contrast to the stalwarts, new fast-growing companies frequently have short earnings histories, and often experience greater earnings volatility. Hence, the earnings histories of fast-growing companies are less reliable in projecting future earnings growth.
As for cyclical stocks, as one investment book points out, "valuations based on earnings can be problematic ... particularly if they are at their high points. The valuations based on the 10-year historical ratios are probably the most appropriate, but still pose difficulties for a cyclical company." 1
Finally, in calculating a company's earnings growth rate, "you need to determine whether growth should continue at that same rate. Studying the firm, its products, and its competitive environment will help guide your decision to adjust the growth rate up or down." 2
1. Maria C. Scott and John Bajkowski, Stock Investing Basics, (Chicago: American Association of Individual Investors, 1995), p. 72.
2. Scott and Bajkowski, p. 18.
To calculate the growth rate in earnings of a company, let's take the firm Procter & Gamble as an example. The website MSN Money gives the earnings per share (EPS) of Procter and Gamble from 2000 to 2009 as follows:
Ten years of data means that we have nine yearly periods of earnings. In the nine years from 2000 to 2009, Procter & Gamble's earnings per share increased from 1.23 to 3.39. To calculate Procter & Gamble's EPS growth rate over these nine years, we must first calculate the growth multiple. We do this by dividing the latest earnings per share number (3.39) by the earliest earnings per share number (1.23):
3.39 / 1.23 = 2.76 (the growth multiple)
Next we raise the growth multiple of 2.76 to the 1/9 power:
(2.76)1/9 = 1.119
(We use the 1/9 power because the time period we are measuring is nine years. If the time period was five years, we'd raise the multiple to the 1/5 power. If the time period was three years, we'd raise the multiple to the 1/3 power, etc.)
(If you don't have an exponential calculator to perform the computation, you
can use this Internet calculator:
Next we take the 1.119 figure and subtract 1:
1.119 - 1 = .119
Finally, we multiply .119 by 100 to get 11.9% as the average annual growth rate.