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Future earnings are central to a company's value development.

Over time, a company's earnings development is decisive to its share price. More than 75 years ago, the US economist John Burr Williams defined the underlying value of a company as the sum of future cash flows – discounted at a suitable interest rate – that can be expected in the company's remaining lifetime.

Future earnings are key

As minority shareholders, we do not have full control over a company's cash flow. Nonetheless, it is the earnings development that is decisive to returns in the long run, both in the form of running dividends and the value development of the shares.

By the very fact that future earnings are key to a company's value development, it follows that the expected growth in earnings is extremely significant. In the short term, the development of the share price may fall out of step with that of the earnings development. Over the long term, however, they must close in on each other.

Not all earnings growth is equal, however. In other words, a company can grow its earnings in a number of ways, and some of these ways are more value-creating than others.

The most beneficial growth is that which the company creates itself, through increasing the sales of the products and services it offers. This is long-term growth and may be attained either by gaining market share, going into new markets, launching new products or benefitting from increasing market penetration.

If a company is market leader in its home market, but still has room to expand internationally, the sales can increase many times over before a large market share is attained.

Companies with the greatest potential for organic growth can often be found among market leaders within new and fast growing industries and businesses. Good examples are Wal-Mart in the second half of the 20th century, Microsoft with its Windows products and Apple's smartphones.

Early movers

The challenge is, of course, being able to find these companies before the market discovers them. If one can manage that, and one is certain about the future growth, these are companies that can justify a higher price on every cent earned.

Another way to increase earnings is via margin improvements, in the form of lasting cost cuts, economies of scale or price hikes. This can also be seen as value-creating earnings growth, particularly when it can be attained without substantial additional investments. Nonetheless, this is less attractive than organic growth as there is a natural limit to margin improvements. After production has been automated or moved to low cost countries, and the organisation has been through rounds of tough cuts, it is difficult to maintain the pace of cost reductions.

Another disadvantage of cost savings is that these can reduce the future earnings potential. If a company halves its research and development costs, or reduces its sales force, this has a direct impact on the bottom line. The company may also end up lagging competitors. There are good examples of this in the telecoms sector. We see that companies sometimes invest too little in network capacity in order to improve cash flow. This can result in seemingly good results for a period, but sooner or later the company will start to fall behind and customers will move to competitors with better coverage and bandwidth.

Business acquisitions can also increase earnings in a company. Strategically advantageous purchases at the right price can obviously create significant value for a company and its shareholders. Acquisitions require capital, however. As a rule, this means higher loans and risk. Acquisition-driven growth therefore deserves a lower valuation multiple than organic growth.

Another way in which management can increase earnings per share is via share buybacks. Whether this is good or bad for shareholders depends on the price paid. If the share price is well below the conservatively calculated real value of the company, the share buyback is a good use of shareholders' money.

Nonetheless, higher earnings growth driven by share buybacks does not automatically result in a higher share price. In order to finance the purchase of shares, the company must either use its cash holding or increase debt, which may increase the risk in the company and lead to a lower valuation multiple.

For us as active managers, it is essential that we understand where the historic and estimated future earnings growth comes from. If the prospect of organic top line growth is good, we are willing to pay a higher multiple than if the growth comes from acquisitions and higher loans.

When the stock market does not differentiate sufficiently between more and less value-enhancing earnings growth, this can result in over- and under-priced shares. This provides opportunities for active and company-focused investors.

If we look at the US market, we note that over the past three years the broad S&P 500 index has gained 14, 27 and 30 percent respectively, measured in euro. Earnings growth in the same period was modest, however. The P/E level has therefore risen from 13 at the start of 2012 to today's level of around 18, based on the last 12 months' earnings.

Keeping in mind that the valuable top-line growth has been a moderate three percent per year, these numbers serve as good reminder that company values cannot grow faster than earnings forever.