A good growth company can deliver outsized returns to investors. But first, you have to find one.
There are many different financial metrics that are often touted, such as price to earnings ratio, price to book ratio, net asset value, and dividend yields. But today, we are going to take a slightly different tack by looking at two simple metrics: revenue growth and return on equity (ROE).
To start off let us try to understand why these two metrics can be important.
1. Revenue growth
A good growth company should deliver increasing profits over time.
A company can increase its profits in two ways, that is, by increasing its revenue or by cutting cost. The former is better than the latter, in our view. While companies can cut cost to boost profits, there is a limit to how much cost they can cut. At some point, the company will not be able to cut costs without affecting their business.
On the other hand, a company that can grow its revenue at a consistent pace can increase its profits without cutting costs or increasing them. Over the long term, this method of increasing profits might be more stable and sustainable compared to cutting costs.
2. Return on equity (ROE)
ROE is an important metric as it measures the company’s ability to generate profits from the shareholders’ equity.
Equity is the difference between the value of a company’s assets and its liabilities. The assets are required by the company for it to generate revenue which is then used to pay off its liabilities. The remaining profits go to the shareholders.
In simple terms, the ROE is measured by dividing a year’s earnings with the existing shareholder equity. For example, a company with $100 of equity and $10 of profits would have an ROE of 10%.
Bringing it together
A company with excess profits can do two things. One use would be to reinvest the excess cash into the business. But that would only be possible if there is room for the business to expand. That’s where revenue growth comes in.
Yet, revenue growth alone is not good enough. As investors, we would seek companies that are able to expand while earning a good return on its growth. And that is where a consistent ROE was a company grows is desired. If a company is able to grow and maintain a good ROE, that would be desirable. Reversely, if the company is not able to earn a good return out of its business expansion, it might be better off distributing its excess profits to investors in the form of dividends.
In summary, investors can consider taking on these two-simple metrics into their arsenal when they analyze companies. In particular, both these metrics can help provide a starting point for investors to find good growth companies.
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The Motley Fool Singapore contributor Esjay contributed to this article. Esjay does not own any of the shares mentioned.
The information provided is for general information purposes only and is not intended to be personalized investment or financial advice. Motley Fool Singapore writer Chin Hui Leong does not own any of the shares mentioned.