by Greg Harrison.
There are several reasons why earnings growth has slowed over the past two years to a lesser extent than the slowdown in revenue growth. For Q4, analysts expect earnings growth of 8.1% and revenue growth of only 0.6%.
Over the past two years, as earnings growth has slowed, revenue growth has lagged even further. With revenue growing in the low single-digit range, earnings growth has still ended up several percentage points higher. Several reasons have been given for this differential, most notably cost-cutting and share repurchases. To quantify the effects of these factors, we can compare share-weighted EPS growth with net income growth.
When measuring growth in earnings per share, the current share count is used to weight earnings for a company for the current and year-prior periods. This presents growth in earnings from the perspective of an individual shareholder. With this methodology, a shareholder’s claim on the company’s earnings increases if the company reduces its share count, as each shareholder owns a larger slice of the earnings pie. As companies have stockpiled cash of late and generally seen fewer profitable investment opportunities, they have deployed much of this capital repurchasing shares, resulting in a boost to earnings per share growth.
Alternatively, looking at growth in net income shows the increase in the profits of a company as a whole, which is not affected by share repurchases. The difference between EPS growth and net income growth is the result of changing share counts. For the third quarter, net income growth for the S&P 500 is 3.5%, more than two percentage points below the EPS growth rate of 5.7%, meaning that declining share counts have boosted earnings growth. As Exhibit 1 shows, lower share counts have boosted earnings per share growth in the index as a whole, and in each sector except for utilities.
Exhibit 2 depicts the components of share-weighted earnings growth. The revenue growth component shows what portion of earnings growth is due to top-line growth of the business, assuming constant profit margins. The benefit from share repurchases, discussed above, represents the part of earnings growth due to changes in share count. The remainder, other factors, includes any other reasons for higher earnings growth, such as operating leverage, efficiency improvements and cost-cutting.
For the third quarter, this segment is small, with only 0.3% coming from other factors, meaning that the 5.7% earnings growth is primarily due to top-line growth and share repurchases, with minimal help from cost-cutting. Looking ahead to Q4, analysts expect revenue growth of only 0.6%, while earnings are expected to increase 8.1%. With a 1.9% expected boost from share repurchases, current earnings estimates are implying large increases in other factors. This means that companies are either going to realize far more efficiencies than they did this quarter, or that current earnings estimates are too optimistic.
Looking beyond 2013, earnings estimates continue to imply significant gains in efficiency along with continuing share repurchase activity. With markets hitting all-time highs, it may make sense for companies to slow down share repurchases and even consider taking advantage of high prices to issue more shares, which would slow down or even reverse the boost to earnings growth from changing share counts. History shows, however, that this is unlikely and that companies will continue to buy their own shares, both to offset employee stock options and grants and as a way to return capital to shareholders.