The Hidden Truth Behind Earnings Growth
Strong earnings can be a good sign or a dangerous illusion. Here's how to tell the difference.
Understanding the importance of earnings growth is key when trying to assess the quality and value of a business. In his well-known book One Up On Wall Street, Peter Lynch described this connection with a memorable image: “The price of a stock will follow the earnings of the company, just as a dog follows its owner on a walk. The dog may dart ahead or lag behind, but eventually it comes back to the owner.” This quote explains why strong and steady earnings growth is such an important part of long-term investment success.
But growth alone is not enough. What really matters is the quality and the stability of that growth. Not all earnings growth is equal. Some companies report strong results thanks to healthy business improvements. Others may rely on one-time events or accounting tricks to boost short-term profits. In some cases, these numbers are influenced by special effects that make the business look better than it really is.
That is why investors should always look closely at what is behind the growth. In this article, we will take a closer look at different types of earnings growth. We will discuss the benefits and risks of each and go through real examples to better understand what makes growth truly valuable.
With that in mind, let’s get started.
Revenue Growth: The Foundation of Long-Term Success
When we talk about earnings growth, one of the most important drivers is revenue growth. There are several ways a business can grow its revenue, and each tells us something different about the underlying strength of the company.
One common and often reliable form of growth comes from selling more units of an existing product or service. This can happen when demand rises or when a company wins market share from its competitors without reducing prices. For example, a business that produces home fitness equipment might see a sharp increase in sales during times when people prefer working out at home, such as during a global health crisis. Although this type of growth is driven by external trends, it still reflects real customer demand. However, investors should also consider whether this growth is temporary or part of a lasting trend.
Another powerful engine for growth is the ability to raise prices. Companies with strong pricing power can charge more for their products without losing customers. This usually requires a clear competitive advantage. In the case of ASML, pricing power comes from being the only company in the world that can supply the machines needed to produce advanced computer chips. Apple, on the other hand, benefits from its premium brand image. Customers continue to buy Apple products even when prices go up, simply because they view them as better or more desirable than alternatives.
A further source of growth lies in product innovation. Companies that successfully launch new products or services often reach additional customers, increase their pricing potential, or enter entirely new markets. These innovations can be based on new technology, changing customer preferences, or better distribution. A well-known example is Tesla introducing new car models to meet demand in different price segments. In the software world, companies like Shopify have expanded their offering with new features and tools to serve both small businesses and larger clients.
Expanding into new markets is another strategy. When a company enters new countries or reaches new customer segments, it can open up large additional revenue pools. However, this kind of expansion also brings a number of risks. Products that work well in one region might not be accepted in another. Customer preferences, cultural habits, and local competition can all limit success. On top of that, companies often face regulatory challenges, need to build new infrastructure, and must invest in supply chains, staff, and logistics.
For example, McDonald’s has grown into one of the most global brands in the world, but in every new country it enters, it must adapt to local eating habits. That often means changing the menu, sourcing local ingredients, or adjusting pricing strategies. In some regions, the company had to experiment for years before finding the right approach. These efforts show that international growth is not always easy or guaranteed. So there are not only big growth opportunities, but also some challenges.
An other way companies boost their revenue is by shifting from one-time sales to subscription models. This is what we have seen with businesses like Microsoft or Adobe, which turned their software into services that are paid for monthly or yearly. This model not only increases recurring revenue but also improves its stability.
While many of these growth strategies involve uncertainties, they are generally considered to be healthy and organic. They reflect a business that is developing naturally, reaching more customers, and offering more value over time. For investors, this type of revenue-driven growth is usually a positive sign and forms a solid foundation for long-term success.
Cost-Driven Growth: Helpful but Not Infinite
Earnings can also grow even if revenue stays the same. This happens when a company improves its cost structure and becomes more efficient. While this kind of cost-driven growth is not necessarily bad, it can only be repeated a very limited number of times. Unlike growing revenue, which can often be scaled, cost savings usually come with natural limits and should be evaluated carefully.
One example of sustainable cost improvement comes from economies of scale. As a company grows and produces more units, its fixed costs can be spread across a larger volume of output, which improves margins. A good example is Nestlé. When the company develops a new coffee product, it only needs to invest in product development once. That product can then be launched across multiple countries. At the same time, the raw materials required for production can be purchased in large quantities at favorable prices. This scale advantage helps Nestlé maintain a solid operating margin and increase profits as production volumes rise.
Another form of cost optimization comes through automation and digitalization. In the short term, these efforts often require significant investments, but over time they make a company more efficient and reduce operating costs. Amazon is a good example. The company invested heavily in developing automated warehouses. Today, many of these facilities can operate with minimal human labor, which significantly reduces labor costs and increases productivity.
Supply chain optimization is also a common method to cut costs. This includes cheaper production processes, improved logistics, or better purchasing strategies. However, not all optimization is necessarily beneficial in the long run. For instance, LVMH has outsourced large parts of its production and quality control. While this may have reduced costs, it has also weakened the company’s control over product quality. In some cases, such decisions may damage the long-term brand value for the sake of short-term efficiency.
As companies grow, they can also increase their bargaining power with suppliers. This often leads to volume-based discounts, especially for large retailers like Costco, which rely on high volumes and low prices to drive profitability. These effects, however, are not endlessly repeatable. Once supply chains and sourcing have been optimized, there is usually little room for further improvement without sacrificing quality.
Outsourcing can also be an effective strategy. By focusing on their core business and outsourcing non-core activities, companies can reduce capital intensity and improve their margins. This only works well if the outsourced processes are not central to the company’s value creation and do not involve sensitive information. Monster Beverage is a good example. The company outsources the production, bottling, and logistics of its drinks. This allows it to focus entirely on product development and marketing. As a result, Monster operates with high margins and a very flexible business model.
In general, cost savings can improve profitability and are often welcomed by shareholders. But they should not be misunderstood as a long-term growth engine. There is a natural limit to how much can be saved, and many of these measures are one-off in nature. In addition, aggressive cost reductions can lead to unintended consequences, such as declining product quality or a loss of control over key processes. That is why companies need to find the right balance between efficiency and long-term value creation. Margin improvements are certainly positive for investors, but it is important to understand what caused them and to assess each case individually.
Strategic Decisions: A Relevant but Limited Growth Driver
Besides organic growth and cost improvements, companies sometimes try to boost their earnings through strategic actions. These include acquisitions, changes in the business portfolio, and shifts in investment behavior. While such steps can offer meaningful advantages in certain cases, they also carry specific risks and are usually not endlessly repeatable.
One of the most common approaches is acquiring other companies. Acquisitions can help increase revenue, improve margins, and expand the business into new areas. When done with clear strategic intent, these transactions can create real long-term value. A good example is Monster Beverage’s acquisition of AFF. This deal allowed Monster to bring the development of its flavor portfolio in-house, giving the company more control over innovation and branding. Another strong example is Google’s acquisition of Android. What started as a small software startup eventually became the foundation for one of the most successful mobile platforms in the world. In both cases, the acquisitions were closely aligned with the company’s core strategy and opened up new growth paths.
However, acquisitions often come with challenges. Companies may overpay, especially in competitive bidding situations. Integrating a new company can also be difficult, particularly when business cultures or structures differ. In many cases, synergies are overestimated and the actual benefit turns out to be lower than expected.
In some cases, companies try to expand into areas that have little to do with their core business. This kind of diversification often adds complexity without delivering real value and burns through the company’s capital, ultimately harming shareholders.
Some businesses also restructure their operations by selling off parts of their portfolio. This may include assets like real estate, machinery, subsidiaries, or entire business segments. While these sales can create a one-time boost in reported earnings, they are not a sustainable growth driver. In many cases, the divestment of productive assets leads to lower future profits.
Another way to temporarily improve profits is by cutting investments. When companies reduce spending on growth initiatives or maintenance, reported profits may rise. However, this approach is often short-sighted. It can hurt product quality, slow innovation, and give competitors a chance to pull ahead.
Strategic decisions like acquisitions or restructuring can be important for the future direction of a business. In the best-case scenario, they strengthen the company and create new sources of revenue. But they are not without risk, and their long-term success is never guaranteed. Investors should carefully examine the reasons behind these actions and judge their impact in the broader context of the business. Above all, it is important not to mistake one-time improvements for lasting growth.
Financial Engineering: Impactful but Often Misleading
In addition to strategic and operational actions, companies sometimes try to boost earnings through financial methods. These changes do not affect the actual business performance but can still influence reported profits. While some of these tools are legitimate and sometimes necessary, others can lead to misleading signals and should be evaluated with caution.
One example is the use of tax advantages. By carrying forward past losses or relocating parts of the business to regions with lower tax rates, companies can reduce their tax burden and temporarily increase net profit. While these effects may improve the bottom line, they do not reflect actual improvements in the company’s core operations.
Another common approach is to lower financing costs. If a company manages to refinance its debt at better interest rates or optimize its balance sheet structure, it can reduce its interest expenses. This can lead to a higher profit, but again, it is not driven by better products, rising demand, or higher efficiency.
Share buybacks are also frequently used, especially among large US companies. When a business repurchases its own shares, the total number of shares in circulation goes down. This leads to a higher earnings-per-share figure, even if the actual profit stays the same. Buybacks can be a good alternative to dividend payments, as shareholders usually do not have to pay taxes on them right away. This allows compound interest to work more effectively over time. In addition, investors do not need to decide how to reinvest the distributed cash themselves, which makes buybacks a more passive and often more efficient form of capital return.
While buybacks can make sense when a company’s stock is undervalued, they can also destroy value if done at high prices. In such cases, management spends company money without creating lasting benefit for shareholders. Investors should also ask whether the money could have been used more effectively—for example, to fund innovation or long-term growth. In some cases, companies even take on debt to finance share repurchases. This may improve short-term metrics, but it usually does not serve the long-term interests of the business.
Changes to accounting practices can also influence earnings. For instance, extending the assumed useful life of assets or switching to a different depreciation method can reduce expenses and lift reported profit. These changes must follow clear accounting rules and usually require approval by auditors or regulators. However, even if they are legally permitted, they can still distort short-term comparisons and make growth appear stronger than it really is.
The same applies to the release of reserves. When a company built up overly cautious provisions in the past and later releases them, this can result in a jump in earnings. This may be justified in some cases, for example if the expected risk did not materialize. Still, it is important to recognize this as a one-time effect that does not reflect the company’s actual earning power.
In some cases, growth may even be inflated by recording revenue too early or by masking the true nature of one-off effects. A notable example is Celsius Holdings. The company sells its energy drinks to Pepsi, which then distributes the products through its own network. At first, this deal created a huge spike in Celsius’ reported revenue, because Pepsi bought large volumes to build up its inventory. However, these cans had not yet reached end customers. As a result, the strong growth turned out to be temporary. In the following quarters, Celsius’ revenue declined sharply because Pepsi had to reduce its inventory before placing new orders. This example shows how important it is to understand a company’s business model and to follow the actual flow of goods and payments.
Among all the categories we have discussed, financial adjustments are the ones I view most critically. They often produce results that are not sustainable and may create a distorted picture of a company’s health. Investors should pay close attention to these effects. They should ask whether the reasoning behind such actions makes sense and whether there is a clear benefit for long-term shareholders.
Bonus: But how much earnings growth should we actually expect from a company?
In most cases, earnings growth does not come from a single source. Instead, it results from a mix of the different growth types discussed in this article. That’s why it’s so important to understand the quality of that growth. It is not only about whether earnings rise, but also how and why they do.
There is no fixed rule for how high growth needs to be. However, as mentioned earlier, a company's share price often follows its earnings over time. Once we have formed an idea of how strongly a company might grow in the future, the key question becomes whether that level of growth is enough to justify an investment. When we take on the risk of investing in a company, we want to be rewarded for that risk in the form of returns.
If a broad global index like the MSCI World can deliver five to seven percent annually over the long term, without exposing us to the specific risks of a single business, then it makes little sense to invest in a company that offers lower or similar returns. Taking on company-specific risk only becomes worthwhile if there is also a meaningful return premium.
That is why individual investments should offer a clear advantage in terms of growth and expected return. How large this premium needs to be depends on the specific business, its model, its market position, and the competition it faces. But evaluating that in detail is a topic for another day.
Final Thoughts
In this article, we have seen that there are many different types of earnings growth. Some are recurring and stable, while others are one-time effects. Some create lasting value, while others may be harmful over time. Each type of growth brings its own opportunities and risks, and not all of them deserve to be valued equally.
What matters most is understanding where the growth comes from. As investors, we need to look beyond the surface and examine the true drivers of profitability. It is not enough to see that earnings are rising. We must ask whether the underlying business is becoming stronger, more resilient, and better positioned for the future.
Earnings growth is not just about size. It is about quality, consistency, and the ability to endure. In the end, it is this understanding that helps us make better decisions and avoid being led by the dog instead of following the owner.