While understanding a company’s performance its either by fundamental analysis or technical analysis or qualitative analysis or the combination of any two or all of the three.
But one thing which remains common is that the business or company’s past performance.
Past performance provides insights into the growth rates and gets a clear understanding of the other pillars of the company’s financial strengths.
There is one thing to note that, while we view the past performances of the company, we definitely get an idea of how the company has performed in the past and not how the company will perform in the future!
So, how do you decide the company’s future based on past performance?
What are the parameters which would help bridge and understand the performance gap which is yet to come?
In this blog article, let us understand the company’s growth potential by evaluating various parameters.
Some experienced traders/investors exclaim that “there is a simple equation to find out growth potential stocks!”
Really?!
The crux is that the return on your investments depends upon the future growth of the company.
Therefore, harnessing its growth potential is essential to making sound investment decisions.
Spoiler Alert:
In this blog article, you will understand various ways in which we can understand a company’s growth potential.
Before we begin let’s deep dive into the highlights and some very common ways investors use to calculate growth potential.
Analysts and their Predictions
When I initially started my journey of investing, I would find the company’s analysis ‘frustrating’ and would go on and find an analysis report by an Analyst for insights and findings.
But then there are thousands of equity analysts that offer predictions about the expected growth rate of a company by sifting through volumes of data and information.
After years I realised that, while these analysts are definitely experts in their field but there are chances that their predictions can be way off the mark.
Hence, definitely not a good foot to step on for starting with investment decisions.
Historical EPS Performance
Another redundant stuff I noticed was, there ‘EPS’ mentioned in every 8 out of 10 equity analyst reports.
The purpose of EPS rather than the historical EPS is to gauge the growth prospects of a company is by looking at its growth over the last decade.
This data is handy to understand the scope from the futuristic perspective.
I remember one of my relatives gave way more importance to this parameter but it was completely counterproductive because in some cases as the company grows, it becomes increasingly difficult to maintain its rate of growth.
Hence, while the historical EPS performance can be a good way to assess the growth of the company to date while estimating its potential, it is important to consider the fact that as the company grows, its growth rate tends to shrink.
Return on Equity
And the hero of all the parameters is ‘ROE’.
Return on Equity!!!
Analysing the ROE of a company for your portfolio building is like mortar and cement for the construction of infrastructure.
A company with a history of constantly increasing Return on Equity is usually perceived as a good sign for the growth potential of the company.
However, this is evidently looking at the company dynamics in a simplified manner.
Theoretically, if the company reinvests its entire earnings, then its Return on Equity keeps increasing.
Practically this doesn’t hold true!
In the real world, a company cannot continuously reinvest its earnings or even a constant part continuously, also it depends on the nature of the business.
The company might decide to pay out dividends or replace/maintain equipment that might not contribute to the growth of the company.
Hence, when we finally thought we stumbled across a parameter that could be effectively used to understand the growth potential of a company, the parameter on a standalone basis doesn’t prove to be effective.
Hence, it is more to EPS or ROE or equity reports!
Let’s find out more…
To understand a company’s growth potential, one must first aim at the survival potential of the company.
Meaning its main source of earning which drives it to sustainability.
Now the sustainability helps, our focus should be on understanding the ‘Sustainable Growth Rate’, which is the maximum rate at which a company can grow without taking on more debt.
As an Investor, you would definitely want to invest in a company that can fund its growth with its earnings……Right?
Sustainable Growth Rate = Return on Equity x (1 – Dividend Payout Ratio)
In simpler terms, this equation takes the RoE ratio and makes adjustments for dividends paid out by the company.
This gives you a clearer picture of the expected growth rate.
Note that ‘Sustainable Growth Rate’ is the maximum rate at which the company can grow.
This value is more than the actual figures.
As an investor, I’m sure you would be more interested in the realistic rate than the maximum expected rate.
Therefore, Sustainable Growth Rate is not ideal.
Let’s consider a scenario where a Company holds on to long-term debt to boost its operations and increase its earnings.
Here the shareholder equity figure will remain the same, the earnings would rise showing a higher RoE ratio.
In such cases, the RoE can tamper with since the debt has not been taken into account.
Also, since RoE is the ‘hero’ component of the Sustainable Growth Rate, it is not accurate either.
Also, there is no chance of considering the amount spent by the company and repairs and maintenance.
Therefore, to get a more realistic assessment of the growth potential of the company, it is hence important to take the long-term debt into consideration.
Therefore, here the once hero ROE becomes void!
What next?
The sidekick ‘Return on Capital ratio’ becomes the new hero.
When we consider the total of depreciation and amortization expenses and deduct it from the reinvested earnings to get a more accurate estimate of the amount available to the company for pushing growth.
To put this in an equation:
Realistic Growth Rate = (Net Income – Depreciation – Amortization – Dividends) / (Shareholders’ Equity + Long-term Debt)
This is the closest value that one can get to harness the growth potential of a company!
Do you think we have achieved perfection?
A big, fat, gigantic, No!
There are several assumptions that are still a part of this estimate.
Sigh!
However, one can consider this equation and go with it because it does offer a fair view of how fast the company can grow.
The comparative basis on the historical EPS based on this gives an optimistic approach towards our perspective.
Also, not to forget about the earnings of the company over the last decade.
Consistent growth in earnings can be considered as a good sign too.
Calculating a company’s growth potential is not easy, but the good news is, it is possible to get a perspective and narrow down our chances and that’s what counts/
Remember that this is a probability and possibility game were based on the past performances of the company we are understanding some futuristic views, hence one can never attain perfection and ideal conditions.
Everything and anything related to investment is risky and therefore this game needs to be played with caution.
There’s not no perfect way to estimate a the growth potential of a company, every renowned growth strategist has their own style of picking of growth stock!
Hope this blog article was helpful!
Happy Investing!
Until next time…