Stock price rises over time based on the quality of earnings and on how long those earnings can be reinvested at high rates of return. A business generating consistent high ROE and growth in revenue and book value compounds its re-invested earnings at a rate of return at least equal to its ROE, assuming no dividend payments. The rate of return (ROE or ROIC) ought to be high enough to leave room for expansion. It is easier for ROE to go from 20 to 40, than from 40 to 60.
In addition to earnings growth, prices move according to the multiple people are willing to pay for the earnings. It is therefore important to buy the earning power at a relatively low multiple to allow for multiple expansion on top of the earnings increases. Such expansion generally occurs during a period of growth acceleration.
These are the “twin engines” of 100-baggers (Christopher Mayer, Thomas Phelps). Huge growth in earnings and a rising multiple.
In sum, a business, preferably small to mid-cap, with good quality earning power that is growing its book value while consistently generating high ROE bought at a relatively low multiple could yield extraordinary results over time, provided one is patient enough.
Checklist
- Revenue Growth
- Book Value Growth through retained earnings
- Consistent high ROE (starting at 20, no extreme) with minimal dividend or debt
- Available at a decent multiple with room to expand (on top of earnings growth)