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Of all things in a company, an average investor seems the most enamoured with earnings. Especially the growth in earnings. A company that has managed to grow its profits by a factor of 5x to 6x over the last few years is dubbed as a super achiever. And its stock continues to break new grounds quarter after quarter.



However, the question that begs itself is, should earnings growth be given so much of importance? Should other things be completely ignored?



Certainly not. Earnings growth is important no doubt. But what is equally important is the quality of that growth.



Most people are aware that stocks are different animals than bonds. In the case of bonds, the coupons do not increase year after year. They remain virtually unchanged. However, stocks are different. A company can keep increasing earnings year after year, thus giving the investor a growing stream of coupons.



So far so good. But this is only one half of the story. We believe that most investors start losing the plot from here on.



Let us go back to our example of bonds and stocks. If we double the investment in bonds, our coupon also doubles. This fact is as clear as crystal. But a similar fact related to stocks goes largely neglected by an average investor. When a company announces that it has doubled its earnings, investors become happy. They immediately start rewarding the company’s stock price. Most of them simply do not bother to check whether the investment in the company has also been doubled or a lot more money has been invested.



In other words, there is nothing extraordinary in a company that grows its earnings by say 50% but grows its overall capital base by 100%. Unfortunately, such companies abound in the stock markets. And they do a very bad job of reporting the truth. They will happily tom-tom the growth in earnings but will completely ignore the growth in capital that has been required to achieve that sort of earnings growth.



Thus, it is the duty of an investor to properly ascertain the facts before going gung-ho about the strong earnings growth that a company has achieved. More often than not, the return on capital employed of a company gives a very good idea about the company’s quality of growth in a very short time.



If the strong growth in earnings is not accompanied by a consistently falling return on capital employed, then the company under consideration could score high on the quality of growth part. However, if strong earnings trend is accompanied by a falling return on capital employed numbers, then the investor has to be wary. Quite often, such investments are one’s ticket to the poorhouse. It could be a ticking time bomb that could well end up destroying your savings. Thus, the next time you come across a company that proclaims strong earnings growth, do not forget to check the quality of earnings as well.

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Category Shares & Stock, Other Articles by - Equitymaster 



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