earnings growth: velocity vs. acceleration

velocity vs. acceleration

For investors, earnings velocity is the rate of change of earnings.

Earnings acceleration is the rate of change of velocity.

Examples:

If a company is growing earnings per share at a steady +10% annual rate, it has earnings velocity of +10% and acceleration of 0.

To have earnings acceleration, the rate of earnings growth has to increase.  The growth rate pattern has to be something like:  +10%, +12%, +15%…

Both velocity and acceleration can be negative as well as positive.  If velocity is negative, earnings are shrinking.  If acceleration is negative, the rate of earnings growth is slowing down.  For growth investors, both are bad signs.

as applies to growth investing

Having any earnings per share growth is better than having none.  Having eps growth that’s fast, and faster than that of the average stock, is an important characteristic of attractive growth stocks.

Having eps acceleration is also important.  Its presence typically creates the largest price earnings multiple expansion.

Acceleration is a two-edged sword, however.  Securities analysts looks for signs of earnings growth deceleration as an early warning sign that a company’s period of superior growth–and therefore of its attraction to investors–is coming to an end.  So it’s often the case that the PE will begin to contract, even though absolute growth is high, because that growth is starting to decelerate.

why this can be important:  performance implications

This can create an odd situation between the performance of two stocks, A and B.

Annual growth of A’s earnings: +20%, +35%, +45%, +25%.

Growth of B’s earnings:  +10%, +12%, +15%, +18%.

In the first two years,  Stock A most likely has outperformed Stock B.  By year 4, B is most likely outperforming A, even though the rate of growth of A’s earnings is continually better than B’s.  That’s because A’s earnings are beginning to decelerate, while B’s are not.

 

 

 

 

 

 

 

Apple (AAPL) as a growth stock

Apple is among the most successful growth companies of the past ten years.  However, AAPL has had a most peculiar trajectory as a growth stock.  To my mind, it has barely followed any part of the typical growth stock pattern I outlined yesterday.

How so?

For one thing, the peak price earnings multiple and the peak stock price didn’t coincide from AAPL.  Yes, the company did switch to a much less conservative method of accounting for iPhone profits early in that product’s life, but I don’t mean that.  Even after the switch, the PE didn’t expand while the company was piling up quarter after quarter of spectacular, continually surprisingly strong, earnings performance .  The multiple contracted slightly instead.

For another, it was clear by, let’s say 2012, that the smartphone market was becoming saturated.  AAPL was also facing increasing competition from the Android operating system and from Samsung as a manufacturer of mobile devices.  So we had to think that pretty soon the iPhone profit dynamo would begin to lose momentum.

What about another reinvention?  The issue here has always been:

–Reinvention #1, the iPod, doubled the size of a small company.  Reinvention #2, the iPhone, more than doubled the size of a now-large company.  To repeat the same quantum leap, Reinvention #3 would have to be twice the size of the smartphone.  What would that product be?  Would such a product be possible?  (my answer: probably not)  Is such a product likely?  (not likely at all)

(AAPL has had two subsequent innovations, the iPad and the iWatch.  Neither has created anything like the response needed to be Reinvention #3)

In a nutshell, the elevator speech was starting to give a sell sign–based both on earnings momentum for the company as currently constituted and another possible reinvention.

 

Yet, the stock continued to go up, and to outperform the S&P, until about a year ago.

Why?

More on Monday.