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Morningstar.com's Interactive Classroom

Course 203
Different Types of Growth Rates

Introduction

Suppose you get a tip on a hot stock from a friend of a friend. This company is growing incredibly fast, you hear, and this is an opportunity to get in on the ground floor. But what exactly does it mean when we say that a company is growing? Rapid growth is usually good, but not always, and it's no guarantee of long-term success. It is important to understand the different kinds of growth rates and how to put them in the right context.

Sales Growth

One common measure of growth is sales, or revenue, growth. This measures how fast a company's annual revenues have been increasing over some period of time, usually one to five years. New companies in hot industries can see their revenues increase at eye-popping rates. For example, many Internet companies sport triple-digit revenue growth; between 1995 and 1998, Amazon.com AMZN grew its revenues at an annualized pace of 960%. But such extreme growth can't last forever. Growth naturally slows as a company gets bigger and is thus less able to grow quickly. As of November 1999, about 6% of the small- and mid-cap stocks in Morningstar's database had seen their revenue grow at least 100% annually over the previous three years. Fewer than 2% of large caps (eight out of 452) had grown that fast, and most of those 2% (including Amazon and Yahoo YHOO) were small caps three years ago. But revenue growth isn't enough; a company also has to make a profit. Even if revenue is increasing at a torrid clip, it is entirely possible for a company to grow itself out of business if it's losing money faster than it can replace it through borrowing or issuing more equity. Many Internet companies are in danger of falling into this trap, and some already have. For example, between 1997 and 1999, online sporting-goods retailer Genesis Direct PRTMQ grew its sales from $19 million to $252 million--but its losses grew from $14 million to $156 million. The company filed for bankruptcy in August 1999 and was delisted by Nasdaq the following month.

Earnings Growth

Once a company is profitable, earnings growth becomes a key number. Generating profits is one of the most important functions of a company, and ideally a firm's earnings will grow at a healthy pace along with its revenues. Microsoft MSFT is a good example. From 1996 through 1999, its revenues grew about 30% annually, and its earnings grew about 50% annually. On the other hand, when companies' earnings growth slows unexpectedly, their stock prices usually plummet. That's what happened to funeral-home operator Service Corporation International SRV in early 1999. After years of steady earnings growth, Service Corp. lost half of its market value after it announced its earnings would come in far below what analysts expected. As with any number, earnings growth can be misleading. Sometimes a company's seemingly impressive earnings growth is the result of acquisitions. For example, between 1995 and 1998, USA Interactive's USAI earnings grew an astonishing 786% annually. The company had gone on an acquisition spree during that time, increasing its revenue 50-fold. Much of that growth came from adding completely new businesses (most notably, the USA Network and Sci-Fi Channel cable channels) to the company's income statement, not from organic growth in the existing businesses. It is also possible for a single year of depressed earnings to distort growth rates. For example, Kimberly-Clark KMB, maker of Kleenex and many other products, grew its earnings a seemingly impressive 227% annually between 1995 and 1998. But the company's reported 1995 earnings were depressed because of a $1.4 billion merger-related charge, so that three-year growth rate is misleading. Kimberly-Clark's operating earnings (not including special charges) only grew 2.5% annually during the same period, painting a very different picture. It is easy to put growth on a pedestal, especially in a market that seems to value rapid growth above everything else (including profitability). But although growth rates are certainly an important part of evaluating any stock, they're only one part. Putting them in the appropriate context can help you distinguish between the next Microsoft and a company that is growing its way to oblivion.

Quiz 203
There is only one correct answer to each question.

1 When a company is growing very rapidly:
a. It is no guarantee of long-term success.
b. It is easier for the company to be profitable.
c. The company has to take on a lot of debt.
2 Compared with small-cap stocks, large-cap stocks:
a. Tend to grow faster.
b. Tend not to grow as fast.
c. Grow about as fast.
3 If a company has fast revenue growth but is losing money:
a. It will always start making money eventually.
b. It can grow itself out of business.
c. Its growth will immediately slow.
4 What is the ideal relationship between revenue growth and earnings growth?
a. Earnings growth should be high, and revenue growth should be low.
b. Revenue growth should be high, and earnings growth should be low.
c. Both should be healthy and steady.
5 Which of the following can result in a misleading earnings-growth figure?
a. High revenue growth and low stockholders' equity.
b. Acquisitions and noncash charges.
c. Dividends and high free cash flow.
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