Better way to calculate earning growth rate to have quick glance on company earning quality
I was wondering, what is a better way, to calculate earning growth rate, to have a quick glance on company earning quality?
In ycharts, according to ycharts.com/glossary/terms/eps_growth , the mentioned way is
Compounded EPS Growth = (EPS this period/EPS t periods ago)^(1/t) - 1
However, it only consider EPS during starting period and ending period. It doesn't take consideration into EPS in between the period.
Let's look at both company A and company B.
Company A
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Year EPS "EPS Growth Rate"
2017 6.00 (6.0/4.9 - 1) = 0.22
2016 4.90 (4.9/3.5 - 1) = 0.40
2015 3.50 (3.5/2.2 - 1) = 0.59
2014 2.20 (2.2/1.0 - 1) = 1.20
2013 1.00
Compounded EPS growth rate = (EPS in year 2017 / EPS in year 2013) ^ (1/4) - 1
= (6.00 / 1.00) ^ (1/4) - 1
= 0.56 = 56%
I try to take account into EPS in between period too, by using the following calculation.
Average EPS growth rate = Sum of "EPS Growth Rate" / 4
= (0.22 + 0.40 + 0.59 + 1.20) / 4
= 0.60 = 60%
Company B
=========
Year EPS "EPS Growth Rate"
2017 6.00 (6.0/0.3 - 1) = 19.0
2016 0.30 (0.3/0.4 - 1) = -0.25
2015 0.40 (0.4/0.5 - 1) = -0.2
2014 0.50 (0.5/1.0 - 1) = -0.5
2013 1.00
Compounded EPS growth rate = (EPS in year 2017 / EPS in year 2013) ^ (1/4) - 1
= (6.00 / 1.00) ^ (1/4) - 1
= 0.56 = 56%
Average EPS growth rate = Sum of "EPS Growth Rate" / 4
= (19.0 - 0.25 - 0.2 - 0.5) / 4
= 4.5 = 450%
We can observe the following.
Company B has more "bumpy" earning than company A. Compounded EPS growth rate unable to reflect such, as it only take consideration into EPS during starting period and ending period.
Although company B has higher Average EPS growth rate, it doesn't indicate that it has higher earning quality. The higher value, is caused by a sudden spike jump from 2016 EPS to 2017 EPS. Before 2017, company B EPS is in decreasing trend.
I was wondering, given data of earning history, which is a better way to calculate earning growth rate, to better reflect company earning quality?
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Your formula for compound growth is slightly off:
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(EPS in year 2017 / EPS in year 2013) ^ (1/4) - 1
= (6.00 / 1.00) ^ (1/4) - 1
= 1.565 - 1 = 56.5%
So the compound growth is much closer to the arithmetic average growth in the first case (60%), but still does not match the second case. However, the geometric average is more appropriate to use when taking about compounding growth since growth is a multiplicative function.
The geometric average in the first case would be
( 2.20 * 1.59 * 1.4 * 1.22 ) ^ (1/4) = 1.565
and in the second case it would be:
( 0.50 * 0.80 * 0.75 * 20 ) ^ (1/4) = 1.565
so you get the exact same answer regardless of method.
That said, looking at the actual periodic values will tell you about the variance of annual growth. Certainly the wide difference in the second case needs further analysis - is it due to a product that was released after 4 years of development that could be sustained going forward? Or does it indicate a highly volatile business?
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