When evaluating a company fundamentally, there are three styles of fundamental investing: growth, value and income. The use of the word “growth” principally refers to the projected earnings growth of the company. However, there are other considerations when evaluating a growth company such as management effectiveness. This article is an introduction on how to analyze the growth prospects of a company and some of the key metrics used in the process.
Growth Investing - What defines a growth stock?
It happens when a company's 5-year projected earnings growth rate is 15 percent or higher. However, that can’t be the only thing considered since a company can have a very high projected growth rate when their earnings are starting from a low baseline. Therefore, considerations for its 5-year historical earnings growth rate, revenue growth, gross margins and net profit margins are important. That being said, checking a company’s 5-year projected growth rate is a good starting point to determine whether a company is a potential growth candidate.
For example, O’Reilly Automotive (ORLY) has a 5-year annual projected earnings growth rate of 15.92 percent. You may also notice that it has a historical 5-year growth rate of 20.63%. Both of these values would indicate a history of growing earnings at a high rate and an expectation to increase profits in the future at a high rate. Without any further analysis, this would be a strong indication that ORLY is a growth stock.
You might be wondering who provides the data for the projected earnings growth rate. Sell-side analysts publish this data, and many sites like Yahoo Finance provide this information for free. A sell-side analyst is somebody that often works for an investment bank and publishes their research to the public. Financial websites pick up this aggregated information from a data feed and will post it on their site. For some analyst estimates, you’ll see the number of analysts and the range of estimates. The expected earnings estimate is based on the average estimate of all analysts covering the stock.
Growth Investing - GAAP vs. Non-GAAP Earnings
Looking at the information in the previous image, you wouldn’t necessarily know that the earnings use for the 5-year historical and the 5-year projected earnings growth are different. Most historical earnings-based measures apply Generally Accepted Accounting Principles or GAAP. Whereas analysis use non-GAAP measures, earnings not following Generally Accepted Accounting Principles. There are advantages to including both of these types of earnings in your analysis.
The major difference between GAAP and non-GAAP is that non-GAAP excludes non-recurring or “extraordinary” expenses. It is significant when a company has a large write-off, and there is precipitous drop in their earnings. This will cause all of their historical earnings measures to falter and may not fully reflect the current health of a company. Analysts strip out these types of expenses and will provide you with another perspective that may be more representative of the company’s growth prospects.
Another difference is that non-GAAP excludes stock-based compensation. This exclusion is rather significant since GAAP considers this an expense. Executive stock-based compensation is substantial for some companies and may provide a distorted picture. The following quote from Mercercapital.com illustrates this difference.
“For example, in its investor slide deck for the Q3, 2013 earnings call, Amazon touts a non-GAAP earnings measure called “Consolidated Segment Operating Income” or “CSOI”. CSOI and GAAP Operating Income have a principal reconciling item called stock-based compensation. For the twelve months ended September 30, 2012, CSOI was $1.795 billion, or 2.8x GAAP operating income of $640 million.”
Growth Investing - This is a list of some of the measures that use GAAP earnings:
- Historical Earnings Growth
- Revenue-based Measures
- Margins
- Return on Equity
- Return on Assets
Growth Investing - This is a list of some of the measures that use non-GAAP earnings:
- Quarterly Analyst Estimates
- Annual Analyst Estimates
- Projected Analyst Growth Estimates
- Earnings reported from company that excludes extraordinary items.
Growth Investing - Characteristics of a Growth Stock
The following is a list of parameters that you can use to evaluate a growth stock. We’ve already covered the criteria for historical and projected earnings growth, but other considerations are essential when thoroughly analyzing a company. The following criteria you can use as part of a growth investing plan:
- 5-year projected annual EPS growth > 15%
- 5-year historical annual EPS growth > 15%
- Revenue shouldn’t be growing much less than sales
- Gross Profit Margin > 40%
- Net Profit Margin > 7% for greater than $5 billion in revenue
- Net Profit Margin > 10% for less than $5 billion in revenue
- Return on Equity > 15%
- Return on Assets > 5%
- Debt to Equity < 50%
Growth Investing - Revenue Growth
Revenue is the top line of the income statement and represents the total received by the company over a period, typically quarterly. You subtract cost of goods sold, expenses, taxes, depreciation and other expenses from revenue to get the bottom-line net income for a company.
When discussing earnings growth, understand that it is the growth in earnings-per-share. You calculate it by taking the net income and dividing it by the number of shares outstanding.
While earnings growth is the most significant, it is important to see that the growth is occurring organically. You do this by looking at the revenue growth. The importance of this is that the company may be generating its growth through cost-cutting or through the use of significant leverage.
The revenue growth is often on report for a particular period such as 1-year, 3-year and 5-year. You can also compare the current quarter revenue to the same quarter in the previous year. Analysts also provide projections for sales as well.
Growth Investing - Gross Profit Margin
Gross margin is the percentage of the revenue that you keep after considering all of the costs to produce their goods.
A high gross margin is important for growth stocks. The higher the number, the more money you retain to service debt and cover other costs. If a company is having to slash prices to sell its goods, gross margin will be affected. When evaluating a growth company, a reasonable threshold is a value of 40% or higher.
Growth Investing - Net Profit Margin
Net Profit Margin (NPM) reflects the profitability of the company. One way to look at NPM is how many cents out of for every dollar taken in through sales do you keep. We define a growth stock is therefore, in part, by its ability to “keep” more of its revenue. This will allow earnings to grow along with sales, all things being equal.
As economies of scale, productivity and other factors diminish costs as a percentage of revenue, this allows earnings to grow faster than sales. The ideal minimum value for NPM will vary depending on the size of the company. For a company with sales higher than $5 billion annually, the minimum NPM would be 7 percent. For companies with less than $5 billion annually, the minimum NPM would be 10 percent.
Growth Investing - Return on Assets
Return on Assets (ROA) is a management effectiveness metric that shows the return that the company is generating on the assets of the company. You calculate it by taking the NPM of a company times its Total Asset Turnover ratio (Revenue/Assets).
Growth Investing - Return on Equity
Return on Equity (ROE) is a management effectiveness metric and represents the amount of income the company is generating for shareholders. You calculate Shareholder’s equity by taking the book value of the assets of the company and subtract the book value of the debt. Therefore, the amount left over is what shareholders receive. The calculation for ROE is, therefore, the net income of the company divided by the equity of the company.
Similar to ROA, ROE uses NPM to derive its value. Essentially, ROE is just the ROA of a company times its leverage ratio (Assets/Equity). Since most companies carry some degree of debt, it’s common to see a leverage ratio of greater than one. That means that ROE is generally higher than ROA. However, a significant difference between the two values is indicative of a company with high leverage or debt. It is possible for a company to have negative equity, in which case the they don't generally display the return.
Using ROE isn’t just for analyzing growth stocks. Since it’s a management effectiveness measure, you can use it as a measure for value and income stocks as well. A value of greater than 15% would be a reasonable minimum value, but values closer to 20% of higher would be more typical for a well-functioning company.
Growth Investing - Debt-to-Equity
For a growth company, debt is essential in that it allows a company to grow its revenue-generating assets quickly to expand. For example, a company may decide to raise capital through debt to open a bunch of new stores to capitalize on its popularity. Organic income growth occurs when revenues grow, and costs hold in check.
There is a point where too much debt can be a problem. What if sales growth began to slow, or the cost of debt began to rise. The fixed costs of debt can lead to much more potential volatility in their earnings. During periods of falling interest rates and strong revenue growth, a company gets a reward when carrying higher debt levels. The opposite is true during periods of rising interest rates and a diminished outlook by analysts.
A good rule of thumb is to consider a debt-to-equity (D/E) level of less than 50%. That means that debt represents up to half of the shareholder equity.
Growth Investing - Example
Let’s turn our attention back to ORLY. We’ve already covered its values for its 5-year projected and historical growth rates, but what about the other values under consideration?
For ORLY, the quarterly comparison yields a revenue growth rate of 5.7 percent. Analysts are projecting 2019 and 2020 revenue growth of 6.50 percent and 5.6% respectively. This shows a much lower revenue growth rate than earnings.
For the past trailing twelve months (TTM), ORLY generated revenue of $9.54 billion and gross profit of $5.04 billion. That means that the company generated gross margins of 52.8 percent. That is well above the standard set of 40%.
With over $5 billion in revenue, the NPM of 13.89 percent is also well above the standard of 7 percent for this amount of revenue. That means that they are keeping a significant amount of their sales, which can be retained, invested in the company, pay dividends, share buybacks, etc.
With a high NPM, if the company is effective at turning over its assets, it should also have a high ROA as well. For ORLY, the ROA is at 14.59 percent and is well above the standard.
Once you account for financial leverage, the company is generating ROE of 263.13 percent. This value is extraordinarily high and is representative of a company that has very little equity, a lot of debt or both. Either way, it is a highly leveraged company. The Debt-to-Equity ratio of 966.20 percent also illustrates this.
This last point regarding the debt is significant, particularly if the earnings outlook begins to diminish. This is especially true when considering the relatively low revenue growth of 5 to 6 percent annually. If the cost of debt began to increase, their ability to remain profitable and keep their high margins could diminish quickly.
Growth Investing - Conclusion
Growth investing is a great way to identify stocks that have significant prospects for appreciation. If you can maintain the growth outlook for the company, these types of stocks can trend perpetually. While this article uses fundamental analysis, you could also pair this type of analysis with a trend trading, technical analysis based, trading system for defining entry and exit.
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