Whether you’re looking at growth stocks or value stocks, understanding a company’s growth story is critical to successful investing.
In the last series, we took a close look at valuation metrics. And while valuation is a great way to find attractive opportunities, it’s just one part of analyzing a stock.
The biggest gains usually come from companies that are growing. And understanding a company’s growth profile gives you a better picture of a stock’s potential gains.
It’s especially important right now, as many stocks are hitting new highs. Before buying a stock, you should always dig into the company’s growth numbers. For example, does it have strong growth forecasts for the next couple of quarters?
In part one of this two-part lesson, I’ll go over a few of my favorite measures to help you evaluate a company’s growth potential.
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Today, we’ll start with revenue growth, earnings growth, and free cash flow (FCF) growth.
Revenue growth measures the increase in a company’s sales from one period to the next. For most companies, the terms “revenue” and “sales” mean the same thing. To keep things simple, I’ll use them interchangeably here.
Revenue growth is a great starting point for checking how well a company’s business is doing. It tells us how successful a business is at selling its products or services. If consumers love the company’s products, they’ll buy more over time. Increased sales could also be a result of people buying the more expensive version of a company’s products. Either way, we want to see this number growing as much as possible.
Revenue growth can help determine the potential future price of a stock. The more a company sells, the better its chance to increase its market share. And investors will typically give a higher valuation to a company as its sales increase over time.
Quarterly revenue growth measures the increase in sales from one quarter to the next. This is also called “sequential” growth. This number can help evaluate a company’s short-term performance. But I prefer to look at growth on a yearly basis by comparing quarterly sales vs. results from a year ago. This is especially important for companies with seasonal changes in sales. For example, many retailers see a big jump in sales during the last quarter of the year, thanks to the holiday shopping season.
Many companies reported their fourth quarter (Q4) results over the past month. If I wanted to check a company’s sales growth, I would compare its revenue in Q4 of 2020 to its revenue in Q4 of 2019. The change in these two numbers gives us the company’s year-over-year (YoY) growth. For example, if Company X had sales of $1.5 billion in Q4 2020 compared to sales of $1 billion as of December 31, 2019, revenue would have grown 50% YoY.
Revenue growth = ($1.5B / $1B) – 1 = 50%
While looking at past growth is important, it’s also important to consider a company’s future prospects. The easiest way to do this is by looking at growth forecasts from analysts. You can find these on lots of sites, including Yahoo! Finance. Just punch in a company’s ticker and click on the analysis tab.
If you follow Amazon (AMZN), you’ll see that analysts expect the company to grow revenue by 38.4% YoY when the company reports its next quarterly results. We get this growth rate by dividing the current consensus (average) sales estimate by Amazon’s sales during the year-ago quarter ($104.4B / $75.45B) – 1 = 38.4%.
Revenue is called a “topline” number. It’s a great starting point for analyzing a company, but it doesn’t tell us the full story. Ultimately, investors care more about profits—the “bottomline.” That means we need to look at earnings if we want to get a better look at a company’s operations.
Earnings growth lets investors know if a company is making money after factoring in its costs. A company could have strong revenue growth… but if it’s spending more than it’s bringing in, it’s not turning a profit yet.
As I mentioned above, investors want to see profits. And if a company has strong revenue and strong earnings, we know the company is in great shape.
Similar to revenue growth, quarterly earnings growth measures the increase in net income from one quarter to another. Again, it’s best to look at YoY numbers. Earnings are typically expressed as earnings per share (EPS). EPS is net income divided by the company’s shares outstanding.
For example, if Company X had EPS of $1.25 in Q4 2020 vs. EPS of $1 in Q4 2019, its earnings grew 25% YoY.
Earnings growth = ($1.25 / $1) – 1 = 25%
In a perfect world, a company would have consistent earnings growth. But earnings can sway wildly, especially compared to revenue. For instance, if a company spends millions on a big advertising campaign, its expenses will jump for a quarter or two. That means its earnings will be lower during that time, even though the ad campaign is likely to generate additional sales in future quarters.
Like revenue growth, investors should look at past earnings growth and forecasts for future earnings growth. You can find earnings growth forecasts on the analysis tab of Yahoo! Finance.
Next, we’ll go one more step and look at free cash flow (FCF), which gives us another valuable metric for analyzing a company.
To get FCF, we simply deduct a company’s operating expenses from its net income. This number tells us how well a company is doing in terms of generating cash (after deducting any cash expenses used in operations). In other words, FCF is the money left over after the company pays its operating expenses and capital expenditures. As I mentioned in my valuation lesson last month, cash flow is harder for a company to manipulate than earnings.
In short, FCF tells us how healthy a company is. And growing cash flow helps a company stay flexible. It can use that cash to expand its operations, pay down debt, or return money to shareholders through dividends and share buybacks.
To find FCF, you simply look at a company’s cash flow statement. You can also go to Yahoo! Finance and click on the Financials tab. Next, click on “Cash Flow” and make sure you’re looking at annual numbers.
If we take the Amazon example from above, we can see it had FCF of $25.9 billion on December 31, 2020 vs. $21.7 billion on December, 31 2019. If we divide those two numbers, we find that Amazon’s FCF grew 19.4% over the past year.
FCF growth = ($25.9B / $21.7B) = 19.4%
Since FCF is discretionary money, it typically fluctuates over shorter time periods, depending on a company’s spending. But over the long term, the best companies continue to grow this number.
I’ve just covered three different growth measures that you can use to evaluate stocks. Revenue growth gives us a great starting point. But earnings growth and FCF give us even more information about a company’s growth profile.
These growth numbers are especially helpful in conjunction with the valuation metrics I covered in my previous series of articles:
- Confused by valuation? Here’s a simple guide to get started
- Is this stock cheap or expensive?
- Why Pfizer is a better buy than Johnson & Johnson
Stay tuned. In part two, I’ll show you how to compare two stocks using the growth measures we’ve just covered.