The Motley Fool

Earnings growth must be the first thing on your investment checklist

There are a huge number of different things that an investor can look for in an investment like the price/earnings ratio, the price to book value (or the NTA), the return on equity and so on.

The above metrics are all important to know. Any of them can give a clue to the value of the business you might be investing in. A low price to book value could be telling you that you’re getting a cheap deal. A high return on equity speaks of the quality of the business.

However, I think the key part to any market-beating investment is that the share is very likely to deliver earnings growth in the future.

There’s no point investing in a business with a high dividend yield if there’s a big chance that business is going to reduce the dividend in the very next result.

Telstra Corporation Ltd (ASX: TLS) is a classic example. Its earnings have been projected to fall for a long time due to the NBN. If earnings fall then if the company somehow maintains its p/e ratio then the share price will fall as much as earnings do. A business with falling earnings is likely to see its p/e ratio contract too, worsening returns.

This would be the case for Telstra whether its dividend ratio was 0%, 100% or anything in between.

Companies with lower payout ratios have a better chance for growth because it means that there are more funds to re-invest back into the business. Or, at the very least, it will have more cash on its balance sheet.

Highly profitable businesses won’t necessarily be able to grow their profit in the long-term either. What is most important is the growth of that profit. That’s why I’m steering clear of big banks like Commonwealth Bank of Australia (ASX: CBA) and Westpac Banking Corp (ASX: WBC).

Foolish takeaway

Businesses that are growing revenue and profit will give your portfolio the best chance of delivering strong returns. That’s why your portfolio is much better off being full of quality shares like Altium Limited (ASX: ALU) and MNF Group Ltd (ASX: MNF) over the long-term than the likes of Telstra and Woolworths Group Ltd (ASX: WOW).

Other shares that are also generating strong earnings growth are these exciting options.

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Motley Fool contributor Tristan Harrison owns shares of Altium. The Motley Fool Australia owns shares of and has recommended MNF Group Limited and Telstra Limited. The Motley Fool Australia owns shares of Altium. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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