Revenue Growth

Revenue Growth

One of the most important factors analysts use to determine the expected future stock price is the growth rate of a company. Growth rate calculations are especially important for start up companies which currently have very little net income and expected to have much higher future returns. This is the main reason why startups trade at very high or no P/E. Off course calculating a companies expected future revenue growth has various challenges such as estimating the demand and competitive environment of the company and thereby making an estimation based on conclusions arrived.

As a proxy we can estimate growth by simply calculating the current momentum in growth. A simple method of doing this is by calculating the 5 year revenue growth. We use revenue growth instead of net income growth for the simple reason that net income can increase by cost cutting, which is limiting (one can only cut costs up to the point that it become zero), but revenue can rise in an unlimited amount. For this reason we use the formula

5 Year Revenue Growth = (Revenue in Year 5 – Revenue in Year 1)/ Revenue in Year 1

According to Hewitt Heiserman (see his book “It’s Earnings that Count”) one should look for revenue growth of at least 30% in the past 5 years.

Having high revenues isn’t always a positive sign however. Look to see if a company has increased their revenues because of multiple acquisitions or through organic internal growth. The notes to the financial statements usually indicate this. The notes also indicate where the company hides some of the bad news as they are written in small print.