What is EPS?
Earnings Per Share (EPS) represents a company’s net earnings divided by its total number of outstanding shares. EPS is a great gauge of a company’s profitability and a predictor of stock price appreciation.
The Three Pillars of EPS Growth
EPS growth is important for stock market investors because it’s one of the primary drivers of shareholder returns over the long run. The three factors that drive EPS growth are revenue growth, margin expansion, and share buybacks.
Revenue Growth: The Foundation
Revenue growth is the bedrock of EPS growth. For a company to increase its earnings sustainably, it must grow sales. Revenue growth can be achieved through strategies like:
- Price Increases: Raising the price per unit sold increases revenue if customers are willing to pay more without reducing demand significantly.
- Market Share Growth: A company can grow revenue without expanding into new territories by increasing its share within an existing market. Winning over competitors’ customers or capturing previously untapped demand allows the company to increase its top-line revenue within its core market.
- New Market Entry: Entering new geographical regions or demographic segments opens up entirely new customer bases, allowing the company to grow revenue beyond its current boundaries. This strategy diversifies the revenue base and spreads market risk.
- Customer Retention: Customer retention is especially important for software companies. Retaining customers for a longer period reduces churn and maximizes the lifetime value of each customer. This steady revenue stream from loyal customers strengthens growth and provides a reliable base for further expansion efforts.
- Expansion (Upsell, Cross-Sell, etc.): Increasing revenue from existing customers by offering complementary products, premium versions, or add-ons allows the company to increase each customer’s spend. This approach taps into the current customer base, enhancing revenue without acquiring new customers.
- New Products: Launching new products or services creates fresh revenue streams and attracts new customers, while encouraging existing customers to spend more. This approach diversifies offerings and enhances the company’s value proposition.
Example:
Apple Inc. (AAPL) has seen its revenue growth drive EPS growth over the past 10 years:
Long-term investors who recognized Apple’s ability to consistently grow revenue benefited from Apple’s strong share price appreciation.
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Margin Expansion: Boosting Profitability
Margin expansion occurs when a company increases its profitability per dollar of revenue.
This can happen in several ways:
- Cost Management: Reducing expenses through improved operational efficiency.
- Economies of Scale: Spreading fixed costs over a larger revenue base.
- Premium Pricing: Offering high-value products that justify higher prices.
Margin expansion plays a key role in boosting a company’s earnings, but there’s a natural limit to how profitable a business can become.
That said, when businesses can increase profit margins, it can greatly impact a company’s bottom line and reward shareholders.
Example:
Microsoft (MSFT) expanded its margins by transitioning its business model to a subscription-based approach for products like Office 365 and Azure. The chart below shows how Microsoft improved its operating margin at double-digit rates for years, which had a sizeable impact on Microsoft’s earnings per share over time.
By improving its margins, Microsoft amplified its profitability, driving EPS growth for its shareholders.
Investors must be cautious of companies that cut costs excessively. If cost-cutting undermines product quality or innovation, it can harm long-term revenue growth.
Share Buybacks: Amplifying EPS
Share buybacks directly impact EPS by reducing the total number of outstanding shares. When a company repurchases its shares, the same earnings are spread across fewer shares, increasing EPS even if net income remains constant.
Example:
In 2022, Meta Platforms (META) launched a major share buyback program, repurchasing over $31 billion worth of stock while its stock price was low.
Although Meta faced challenges with revenue growth at the time, the buybacks provided a significant boost to EPS. By 2023, as revenue growth rebounded, it became clear that the buyback program delivered long-term value beyond just a short-term earnings lift.
While buybacks can effectively enhance EPS, it’s important that buybacks are funded by the company’s internal free cash flow, not debt. Also, the company shouldn’t be buying back shares if the stock is significantly overvalued.
External and Internal Factors Influencing EPS Growth
Beyond the three pillars, long-term investors should consider external and internal factors that influence EPS growth:
- Economic Environment: Inflation, interest rates, and GDP growth can impact revenue and margins.
- Industry Trends: Regulatory changes, technological advancements, and competitive dynamics affect growth potential.
- Corporate Strategy: Leadership decisions on capital allocation, R&D investments, and mergers/acquisitions shape EPS trajectories.
FAQ Section
Why is EPS important for long-term investors?
EPS measures a company’s profitability on a per-share basis, making it a key indicator for evaluating potential stock performance over time.
How does revenue growth contribute to EPS growth?
Revenue growth increases a company’s earnings potential, which can directly impact a company’s EPS when managed effectively.
What is margin expansion, and how does it affect EPS?
Margin expansion improves profitability, allowing a company to generate higher earnings from the same level of revenue, which can boost EPS.
How do share buybacks amplify EPS growth?
Share buybacks reduce the number of outstanding shares, increasing EPS even if net income remains constant.
What are the best strategies for identifying companies with strong EPS growth potential?
Investors may be able to spot companies with strong growth potential by looking for companies with sustainable revenue growth, strong margins, and prudent share buyback programs supported by strong cash flows.
TIKR Takeaway
Revenue growth, margin expansions, and share buybacks are the primary drivers behind EPS growth.
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Disclaimer:
Please note that the articles on TIKR are not intended to serve as investment or financial advice from TIKR or our content team, nor are they recommendations to buy or sell any stocks. We create our content based on TIKR Terminal’s investment data and analysts’ estimates. We aim to provide informative and engaging analysis to help empower individuals to make their own investment decisions. Neither TIKR nor our authors hold positions in any of the stocks mentioned in this article. Thank you for reading, and happy investing!
