What it means
Profit is the engine that eventually pays dividends, funds expansion and reduces debt, so how fast it grows is central to a company's story. A business earning $1,000,000 that grows at 10% a year is on a very different path from one that stays flat.
Earnings growth gives you a single figure to compare those paths. It can be measured on different profit lines, such as operating profit, net income or earnings per share.
Earnings per share growth is the version investors watch most, because it reflects what each shareholder gets after allowing for new shares issued or old ones bought back. A company can grow total profit while earnings per share stands still if it issues many new shares.
Growth can be reported year on year, quarter on quarter or as a compound annual growth rate over several years. The compound version smooths out lumpy years and is better for judging long-term performance.
A single strong year can flatter the picture, while a five-year compound rate is harder to manipulate. Quality matters as much as quantity.
Growth that comes from higher sales and better margins is healthier than growth that comes from cost-cutting, accounting changes or one-off gains. Analysts often adjust for unusual items to find the underlying trend.
Earnings growth also feeds directly into valuation. A fast-growing company usually trades at a higher price-to-earnings ratio, because investors are willing to pay more today for bigger profits tomorrow.
If the growth disappoints, the share price can fall sharply even when the company is still profitable. When you read a growth figure in a news story, ask three quick questions: which profit line is being measured, what period is being compared, and does the figure include unusual items?
Those questions will catch most of the ways a growth number can mislead. They take only a minute and will make you a sharper reader of any set of results.
In practice
Real-world examples
Example 1
A subscription software company reports net income rising from $2,500,000 to $3,000,000. That is 20% growth, and the chief executive highlights it in the results announcement. An analyst notes that revenue grew only 8%, so most of the earnings growth came from lower costs.
Example 2
A restaurant group's net income falls from $900,000 to $810,000. The growth rate is -10%, and the finance team investigates whether rising food prices or weaker footfall is to blame. They find that food costs account for most of the decline.
Example 3
A manufacturer is being valued for a possible sale. The buyer asks for five years of earnings and calculates the compound annual growth rate rather than relying on the latest year. This reveals steady 7% growth, which supports a stable valuation.
Think of it
Earnings growth is like tracking how much more money you actually pocket from your business after all expenses.
Formula
Calculation
Earnings growth rate = (Current period earnings - Prior period earnings) / Prior period earnings x 100
Suppose a company earned net income of $4,000,000 last year and $4,600,000 this year.
Increase = 4,600,000 - 4,000,000 = $600,000.
Growth rate = 600,000 / 4,000,000 = 0.15, which is 15%.
For a multi-year view, if earnings grew from $4,000,000 to $5,324,000 over three years, the compound annual rate is the figure that, applied each year, produces that result. Here 4,000,000 x 1.10 x 1.10 x 1.10 = $5,324,000, so the compound annual growth rate is 10%.Case study
Seen in the real world
Alderwood Beverages is an illustrative, fictional drinks company that announced 25% earnings growth in a single year, sending its share price higher. The headline attracted a wave of new investors.
A closer reading of the accounts showed that $700,000 of the $1,000,000 increase in earnings came from selling an old bottling plant. Without that one-off gain, earnings growth was only about 7.5%, in line with the industry.
When the next year's results arrived without a similar gain, reported growth was negative and the share price fell back. The illustrative lesson is that headline growth needs checking for one-off items before it is treated as a trend.
Watch out
Common mistakes
- Taking a single strong year as proof of lasting growth, when a multi-year compound rate gives a fairer picture.
- Ignoring one-off gains, such as asset sales, that inflate the growth rate.
- Calculating growth from a very small or negative starting figure, which produces misleadingly large or meaningless percentages.
Questions
People also ask
What is a good rate of earnings growth?
It depends on the industry and the economy, but a business growing profits faster than its sales and faster than its peers over several years is generally regarded as performing well.
What is the difference between earnings growth and revenue growth?
Revenue growth measures the rise in sales, while earnings growth measures the rise in profit, which also depends on costs, interest and tax.
Why do investors prefer earnings per share growth?
It shows growth per share, so it takes account of new shares issued or shares bought back, which total profit growth does not.