The goal of every business is to grow consistently. If the business is not growing, its returns/market share will be split by more investors and competitions in its industry.
It is important to track the growth rate of any company before buying its shares. As its business fundamentals improves over time, the value of your investment grows as well.
A quarter or annual financial metric (revenue, operating profit, return on equity,…etc) is useless on its own. It is just like having a shoe without its second pair. So therefore the shoe is useless because you can’t wear one without the other.
But whereby you compare a quarter or annual financial metric of a company to its past performances you can tell the trend/momentum of its business.
You must have come across this statement ‘the trend is your friend’. Your investments decision making should be in harmony with the trend of the business.
Knowing the growth rate of companies you can pinpoint strong/great companies during or after an economic recession. You can pinpoint strong companies even when their share prices fall.
The share price in the short term is controlled by emotions and expectation but in the long term the true valve of the business appreciates.
There are two major ways to calculate the growth of a company business metrics.
- CAGR (Compounded Annual Growth Rate)
- Annual/quarterly average rate
These methods can be applied on any financial metric such as earnings, free cash flow, dividends, cash burn rate, debts (short and long term), profit margins etc.
To calculate the growth rate, you will need to pick a time period to calculate its growth.
It could be the last 4 quarters or the past 5 years or 10 years. I usually check the growth rate of business operations for the last 10 years, 5 years, 3 years and 1 year. Then I compare, I want to see a stable growth.
For example, the PEG ratio I calculate the CAGR for the past 4 quarters or past 5 years.
Below shows the dividends given to investors for the past 5 years by XYZ Company.
2015 = 2.40
2014 = 2.20
2013 = 1.80
2012 = 1.90
2011 = 1.75
2010 = 1.74
- Calculate the annual average growth rates of the data above
- Calculate CAGR of the past 5 years, 3 years and 1 year.
(Then perform a momentum analysis on these growth rates.)
2015 = (2.40 – 2.20)/2.20 × 100
2014 = (2.20 – 1.80)/1.80 × 100
2013 = (1.80 – 1.90)/1.90 × 100
2012 = (1.90 – 1.75)/1.75 × 100
2011 = (1.75 – 1.74)/1.74 × 100
For the past 5 years the yearly growth rate are as follows
2015 = 9.90%
2014 = 22.2%
2013 = -5.26%
2012 = 8.57%
2011 = 0.57%
CAGR = (last value/first value)(1/number of years) -1
5 years CAGR = (2.40/1.74)(1/5) -1
3 years CAGR = (2.40/1.90)(1/3) -1
1 year CAGR = (2.40/2.20)(1/1) -1
From the calculations above
5 years CAGR = 0.77%
3 years CAGR = 1.59%
1 years CAGR = 1.00%
The previous growth rates should be compared to the present growth rate. Investors like the growth of financial metrics to be steady and stable. However, it is not always so, as seen from the examples above.
A good rule of thumb is, if you see two straight declining years of more than 5%. It is a red flag and such a business should be avoided.
If you want to play safer and minimize your risk two straight declining years should be completely avoided.