Revenue growth, especially average revenue growth over the previous three to five years, is a helpful metric for investors to consider when evaluating potential growth stocks. However, looking at revenues, even rapidly growing revenues, can be misleading for investors because revenues viewed in isolation fail to indicate a company’s current profitability or future prospects for profit.
More important metrics and factors for investors to use in identifying strong potential growth stocks include profit margins and earnings growth, efficient use of capital and a company’s position within its industry.
Unless the companies can go to the capital market to raise debts or to issue additional shares, growth is most commonly fueled by profits. Rapid growth of a business requires substantial capital expenditures. This is one reason that growth stocks don’t typically offer much in the way of dividends, because the company retains earnings to spend on business expansion.
The two best profitability metrics for investors to consider in evaluating growth stocks are operating margin and net margin. Operating margin is not only a solid gauge of pretax profitability but also a good measure of the strength of a company’s management. Operating margin reveals how successful a company’s executive team is in controlling operating costs such as materials, labor, and shipping.
As with all equity evaluation metrics, operating margin is most helpfully examined in relation to industry averages, especially when compared to a company’s most direct competitors. A company with a substantially higher operating margin than its industry peers has distinct advantages, both in terms of financial stability and in having the extra working capital to devote to business growth or to more easily weather industry or general economic downturns.
Net margin reveals a company’s bottom-line profit position, which is the proportion of total revenues that translate into actual net profit. Net margin, like operating margin, is most useful when compared to the margins of industry peers. It’s also important to consider the general trend in profitability over time, whether a company’s profit margin is expanding or shrinking.
A good variation to gauge a company’s net profit is earnings per share (EPS), which reveals the per-share allocation of a company’s profits. EPS is an especially important metric, because it is a key factor in determining share price, and also because it is used in the calculation of another important performance metric, the price/earnings ratio (P/E).
Growth investors like to see projected EPS growth of at least 10 to 15%. However, it’s important to take projected EPS growth figures with a healthy dose of skepticism. Projected EPS figures are just estimates from analysts, and estimates sometimes turn out to be woefully inaccurate.
Efficient Use of Capital
A strong clue to a company’s growth potential can be gleaned from examining how efficiently it utilizes capital in order to expand market share or to develop profitable new products or services.
Two good measures of capital efficiency are the return on assets (ROA) ratio and the return on equity (ROE) ratio. Both metrics are designed to show how effectively a company utilizes existing assets to generate additional profits. The ROA, or net earnings divided by total assets, shows what kind of return a company generates by utilizing its asset base. ROE, or net income divided by total shareholders’ equity, reveals how effectively a company generates a return on the capital provided by investors.
There’s no simple mathematical formula that delineates the strength of a company’s position within its particular industry, but this can often be a critical factor in determining a company’s growth prospects. Growth investors seeking to identify companies with the highest potential also examine less tangible factors such as a company's success in establishing itself as a brand. Prime examples of strong brand presence are The Coca-Cola Company (NYSE: KO), Apple Inc. (NASDAQ: AAPL) and Nike Inc. (NYSE: NKE).
Another industry position factor to consider is a company’s economic moat, or whatever competitive advantage it has that provides it with some level of protection in regard to its market share and profits. Economic moats can exist in the form of low-cost production capabilities, proprietary technology, or high barriers to entry by new companies in an industry. Long-established cell phone companies such as Verizon Communications Inc. (NYSE: VZ) have economic moats by virtue of their massive existing communications infrastructure. It would require huge investments of capital and a considerable amount of time for a new cell phone company to build a communications network sufficient to compete effectively with Verizon.
Aiming for Growth
Growth stocks are commonly defined as stocks with reasonably expected annual growth potential in share price of approximately 10 to 20%. That’s essentially a stock that is expected to double in price within five to seven years. In reality, a good growth stock is any stock whose share price appreciation outperforms overall market or industry averages. To pinpoint the very best growth stocks, investors consider a company from a variety of angles that provide insight into its efficiency, profitability and industry position.