Growth Ratios

Most analysts agree that growth is a good thing, because it is necessary to maintain a competitive edge, to expand profits and lines of business, and to maintain control over expenses so that profits do not erode over time. However, growth should take place in a controlled manner, and under the careful guidance of management. Overly rapid growth brings numerous problems with it.

eKEY POINT

Growth, although a positive and necessary process, is dangerous to the financial health of the corporation unless it is planned and controlled. One of the more important fundamental tests you can perform is one that measures not just growth, but management's ability—and willingness—to control the rate of growth.

For each corporations in which you invest, you need to know the (1) growth in sales and (2) growth in earnings per share. These ratios are useful not only for watching the rate of growth and ensuring that it continues, but also for determining that growth is not occurring too quickly.

Growth in Sales

You probably already recognize that the study of sales volume, by itself, is not a reliable indicator. Volume is only part of the expansion and profitability equation. However, in terms of measuring the rate of growth, comparisons of increases in sales levels from year to year are very instructive. This ratio helps you to identify consistency in the rate of growth, and also to identify sudden changes in that rate.

The formula for growth in sales is shown in Figure 6.9.

This formula begins with the identification of a base year, the starting point to which all future years will be compared. In developing

FIGURE 6.9 Growth in Sales (rounded to one decimal)

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e KEY POINT

Testing and tracking sales by itself is not adequate fundamental analysis. However, carefully watching sales as an indicator of growth pattern provides you with valuable fundamental information about management.

trends, the longer the period, the better. If you have the information available, you may decide to pick a far past base year. However, you might want to pick a base year that makes sense based on the history of the corporation. For example, the current growth in the stock might be based on a merger 12 years ago. The year of the merger or the first full year of combined operations would make a sensible base year.

As an alternative, you can identify the base year as the year you purchased stock in the company. In that way, you tie in the portfolio analysis to your own investment experience.

Growth in Earnings Per Share

A second ratio for identifying growth involves comparisons of earnings per share. In a growth stock, you should reasonably expect that the earnings per share would increase over time, assuming that profitability is reflected in market perceptions of value. And if that perception does not respond to the fundamental history, that could be an indication of some other problem. For example, the industry itself might be out of favor with the investing public, or your company might be suffering from negative news of a direct competitor.

FIGURE 6.10 Growth in Earnings Per Share (rounded to one decimal)

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e KEY POINT

Just as earnings per share is an important measurement of growth, the rate of change from year to year demonstrates how well one company is able to continue profitable growth from year to year. A truly professional management team will be able not only to create profits, but to continue a satisfactory rate of growth over many years.

The ratio for growth in earnings per share is shown in Figure 6.10.

Like the growth in sales ratio, this ratio compares the latest year's figures to those in a base year. You should select the base year on the same reasoning as that used for growth in sales. If you use both of these ratios, use the same base year. The selection should also make sense as a base for each of the ratios involved. A well chosen base year is essential in ensuring that the results of the growth tests are reliable.