Let's talk about the Container Store Group (NYSE:TCS) for a moment. If you look at the current quarter's estimate and compare it to the "actual" analysts' figure for its EPS four quarters ago, its EPS growth rate is -25%. If you look at the latest reported quarter (GAAP EPS) over the same quarter last year, its growth rate is 3,400%. If you look at the latest annual figure compared to the previous year, its growth rate is -41%. If you look at the trailing 12 months' EPS and compare those to the previous 12 months, its growth rate is -36%. The Container Store's three-year EPS growth rate is -5%, but its five-year EPS growth rate is 15%. How crazy is that?
This problem is hardly unique to the Container Store. Most companies have widely varying EPS growth rates depending on what periods you look at. The discrepancies are mind-boggling. And that's not even considering other growth numbers, such as sales, book value, free cash flow, and operating income.
So how do we best measure a company's growth?
Well, let's first look at why you'd want to measure growth. I can think of three reasons.
- One is momentum-related: You want to ride the wave. It's well-known that a company that posts strong growth numbers in its latest quarterly statement is likely to increase in price, and that price increase doesn't only take place in the first day or two, but tends to last a few weeks. High growth numbers make investors optimistic, and following investor sentiment can lead to short-term profits.
- A second reason is more forward looking: you want to be able to anticipate growth and invest in stocks that are going to post strong numbers in the future. Here analyst estimates can be valuable, and past growth rates, if used correctly, can help. This article won't be discussing these measures, which were the subject of an earlier article, "Predicting EPS Growth."
- A third reason is value-related and is almost the reverse of the first two. For a long-term investment, you want to choose stocks whose growth is going to exceed expectations. In other words, you want to choose companies whose current growth is either a) discounted or ignored by the market, b) signifies little compared to other signs of future growth, or c) is weak but shows strong signs of improvement, signs that may be hidden to other investors.
As you can see, not only can growth be measured in all sorts of different ways, but also those numbers can have a variety of different interpretations depending on what you're looking for in your investments.
Earnings Growth and the Negative-Number Problem
The standard way to measure the growth of anything is to divide the present figure by the past figure and subtract one. This is equivalent to taking the present figure, subtracting the past figure, and then dividing by the latter.
Measuring earnings growth, however, is quite unlike measuring the growth of other things. If you're measuring the growth of a tree, a person, a supernova, or the population of cells in a Petri dish, you're not going to start with a negative number. But with earnings (as with book value, free cash flow, operating income, and a number of other financial measures), the starting point could easily be negative. In fact, almost all young companies occasionally report negative earnings, and some companies can report them for years.
If past earnings are negative, using division and subtracting one will give you a growth rate below -100%, which is not just impossible, but wrong. A company that has turned a corner and is now earning healthy returns should display a positive growth rate. To solve this problem, we take the present figure, subtract the past figure, and divide by the absolute value of the latter.
This, of course, leads to some weird growth rates. A company that has gone from earning -$0.01 per share to $0.02 per share will show a growth rate of 300%, while a company that has gone from earning -$0.03 per share to $0.02 per share will show a much lower growth rate of 166%. To ameliorate this, and to measure earnings growth when past earnings are $0.00 per share, I recommend using a minimum of $0.05 per share in the denominator. So if present EPS is E_{1} and past EPS is E_{0}, the final formula would be (E_{1}-E_{0}) / max (0.05, |E_{0}|). Using this rule, the first company would show a growth rate of 60% and the second a growth rate of 100%.
Some people argue that growth figures based on negative numbers in the denominator are meaningless. But nobody, as far as I know, has come up with a satisfactory solution to the problem. One needs to scale growth: if two companies increase their earnings by $0.30 a share and the first was earning $4.00 per share while the second was earning $0.50 a share, they have equal growth but not equal growth rates. So the same is true if one is comparing companies earning -$4.00 a share and -$0.50 a share. In both cases, the first company increased its EPS by 7.5% and the second by 60%.
Adjusting Earnings
GAAP earnings should be adjusted before use. The numbers available either include or exclude "extraordinary items," but even excluding these, a number of "special items" (non-recurring pre-tax items such as moving expenses, severance payments, write-offs, write-downs, and reserves for litigation) remain, and should be taken into account. My rule of thumb is to deduct from (or add to, as the case may be) net income 80% of these. So to get an EPS measure, you take net income, deduct 80% of special items, and divide by the fully diluted share count.
Another option is to use analysts' numbers, which reflect their judgment of special items and other one-time costs or income. These sometimes differ significantly from the EPS you get with the above approach; it's probably best to take both numbers into account.
Fifteen Growth Measures
Now that we've done our homework, we can make a little better sense of the Container Store's growth. I'm going to look at 15 factors, explain how I calculate each one, and what I do with them. This is by no means an exhaustive list, and others might find different numbers useful, but I think this gives a pretty good picture.
- Book value growth. Warren Buffett famously relied on this measure for many years, though he has now abandoned that practice. Book value growth of zero to fifteen percent seems pretty healthy to me. A lot more or less than that could be a warning sign of upcoming instability. The Container Store's book value growth over the past 12 months is 6.4%, which is nice.
- Dividend growth. The Container Store doesn't pay dividends, so this is inapplicable, but it's a good thing to look at. Companies that are increasing their dividends are often healthier than companies that are decreasing them.
- Projected annual EPS growth. If you compare the analyst estimate for the current fiscal year to the analyst actual figure for last fiscal year, you end up with a modest 9.5% growth for the Container Store. But if you compare it to the GAAP EPS adjusted for special items, that drops down to -28%.
- Actual annual EPS growth. If you factor in special items, the Container Store's trailing 12-month EPS growth (that is, compared with the previous 12 months) is -14%.
- Projected quarter-to-quarter EPS growth, current quarter. The Container Store is projected to earn -$0.10 this quarter, which is lower than the "actual" EPS of the same quarter last year (-$0.08). So that's a 25% decrease. If you compare it to GAAP EPS of that quarter, adjusted for special items, the number becomes worse: a decrease of 67%.
- Actual quarter-to-quarter EPS growth, most recent quarter. Here we have our first piece of good news: the Container Store's quarter-to-quarter EPS growth (the most recent quarter's compared to the same quarter last year), after adjusting for special items, is 651%. But since this is such an outlier, it's not necessarily such good news.
- Employee growth. The staff at the Container Store, using annual employee numbers, has shrunk by 3%.
- Free cash flow growth. While the Container Store has had positive free cash flow, that has shrunk by 36% between the trailing 12 months and the 12 previous months.
- Operating income growth, most recent quarter. Here the Container Store shows a very healthy 32% growth, from $21 million to $28 million.
- Operating income growth, last four quarters. This is the average of the last four quarters' growth over the same quarter the previous year. The Container Store's growth averages 40%, which is truly excellent. In my view, these last two numbers are more significant than any of the previous numbers, and portend quite well for the company's future.
- Operating margin growth. I look at the difference in one year's operating margin from the previous year's, every quarter over the past three years, and take the median. Here I'm looking for stability. The Container Store's growth here is about 1%, which is pretty ideal. You really want to be wary of companies that post huge growths in operating margin, because that means that either their operating earnings are increasing a lot faster than their sales or they're manipulating the numbers.
- Sales growth, three-year. The Container Store's number here, 3.11%, is a little below average for the sector. But we're not looking for very high numbers here - huge sales growth is not ideal.
- Sales growth, one-year. Here we're very average: 4.4% annual sales growth.
- Sales acceleration. The way to measure this is to take the sales growth of the most recent quarter over the same quarter the previous year, then subtract the annual sales growth, and lastly divide by the absolute value of the latter. Since the most recent quarter's sales increase is 8.8% and the annual sales increase is only 4.4%, the Container Store is showing strong acceleration of sales.
- Sales stability. Here the Container Store fares worse than average. The way I measure this is to take the absolute value of the difference in sales between one quarter and the previous quarter over the last four quarters and divide that by the total sales over the year. The closer that number is to zero, the better. The Container Store's stability is 11%, which is a little too high, in my opinion.
From these numbers, you might think the Container Store is overall in a middling position. Its EPS growth is weak to terrible, but that appears to be compensated by especially strong operating income growth and a nice acceleration in sales.
But in my judgment, the Container Store is in quite a strong position. Operating income growth and sales acceleration are better signs that a stock will beat expectations, in my experience, than EPS growth. In addition, there are a few other signs of healthy growth here. If I had to rate the Container Store's growth on a scale of 1 to 10, I'd give it an 8.
Of course, growth isn't the only thing I look at when I assess a company's prospects. Overall, the Container Store's stock appears to me to be pretty fairly priced, maybe slightly low. My Seeking Alpha marketplace service, The Stock Evaluator, gives it a score of 75 out of 100.
Growth Factor Bucket Charts
Below are the results of backtests of some of these growth measures as single factors, which I've run on Portfolio123. Single-factor backtests are problematic, in my opinion, because every factor interacts with other factors; a single-factor backtest of, say, accrual ratios will show some rather unpromising results even though accruals must be one of the main backbones of any evaluation system, simply because accruals interact with other important factors like earnings growth, earnings yield, profit margins, and return on equity. But single-factor backtests can display some interesting tendencies. My method here is to take Portfolio123's approximation of the Russell 3000, set a minimum price of $3.00 per share, rebalance every four weeks, and measure the decile results for each factor over the last 10 and the last 20 years. The results might be quite different if I were running these tests on cheap small caps, or expensive large caps, or including foreign companies and microcaps, but these charts still give you some valuable clues as to how growth metrics affect price.
First up is EPS growth, measured by comparing the current estimate with the adjusted EPS for the previous quarter/year. The only way I can explain the dip in the ninth decile, which is present in all four decile charts, is to surmise that EPS growth works like most growth factors - a general bell-shaped curve, with the highest values in the middle - except that companies with exceptionally high EPS growth (the tenth decile) benefit from a short-term surge in price after the earnings announcement.
The next chart shows operating income growth, measured by comparing the most recent quarter with the same quarter last year and also by doing the same for the last four quarters. Here the bell curve is quite lopsided: when it comes to operating income, companies with negative growth fare a lot more poorly than companies with very high growth.
Here are three-year sales growth and sales acceleration, which give you very different curves. Notice that with sales growth (the blue and red bars), extremely high is almost as bad as extremely low. That's definitely not the case with sales acceleration.
And lastly, here is book value growth and employee growth. Notice how low the top decile is: you really don't want to be among the fastest growing companies by these measures.
Conclusion
Growth is complicated. It's not easy to measure, and the measurements have to be interpreted wisely. With some measures, you might want to look for high growth, and with others, you might want to look for average growth. It's best to look at companies from all angles, and that means a lot of different growth angles in particular. And don't shy from companies with negative earnings, either in the past or in the present. Every company worth investing in has room to grow.
My marketplace service, The Stock Evaluator, takes all these growth factors into account in its weekly comprehensive ranking of over 4,000 stocks.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.