Sivy on Stocks

7 questions to ask before buying growth
These questions can help determine if you're buying growth that can be sustained.
August 18, 2004: 10:12 AM EDT

NEW YORK (CNN/Money) - In theory, no company should be able to show earnings increases that are way above average for very long. Whenever a business offers opportunities that permit exceptionally rapid growth, those high profits attract more and more competitors.

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As these firms try to undercut each other, profit margins -- and profit growth rates -- deteriorate.

Nonetheless, companies from Citigroup and Procter & Gamble to Microsoft and Walgreen manage to remain stars. They may stall for a few years, as many top stocks have because of the recent bear market, but true blue chips reassert their positions once a new bull market begins.

Such market leaders can succeed in one of two ways: by maintaining a dominant position in a fast-growing industry or by gaining market share and operating more efficiently in an average industry.

In either case, the companies need some sort of competitive advantage -- proprietary technology, patents, or a management system that's hard to duplicate.

But even the most dynamic businesses encounter changing market conditions or tough competition sooner or later, and their growth slows down. So here are seven questions to help determine if a company and its stock -- still has plenty of opportunity ahead of it.

Does the company have a unique product or service?

Growth companies have to earn above-average profits. To do that for any length of time, a company must offer an innovative product or service that isn't readily available elsewhere. For example, major pharmaceutical companies with lots of patented drugs consistently earn higher profits than producers of generics.

Does the firm have recurring revenues?

Truly sustainable earnings growth comes from steadily rising revenues, not from cost cutting, financial restructuring, or lower taxes. The best kind of revenues are recurring. By producing the operating system for the vast majority of personal computers, for example, Microsoft has been virtually assured revenue from operating system upgrades and related software applications.

Is the company early in its growth curve?

Since nearly all growth stocks eventually plateau, make sure you're getting in early. Be careful if everyone is familiar with the company, knows about its success and assumes it will grow forever. Corning enjoyed an enormous growth spurt in the late 1990s as communications companies raced to build networks of fiber optic cable. But once the networks were built, Corning slumped and has yet to fully recover.

Is the company at the forefront of its industry?

Even when an industry is booming, there's no guarantee that all companies in it will continue to prosper. Among pharmaceutical companies, for instance, those that fail to develop a constant stream of new products quickly fall behind the rest of the sector.

Is the return on equity higher than 15 percent?

Some companies are able to show high earnings growth only because they borrow to finance expansion. But they can't borrow forever. Sustainable growth is best funded with the earnings that a company retains after it pays dividends. Those retained earnings are added to shareholders' equity -- and it's the profits earned on such additional equity that provide most of a company's long-term earnings growth. These potential profits can be gauged with a measure known as return on equity, or ROE. As a rule, a company needs an ROE above 15 percent to sustain a growth rate above 12 percent.

Is the company's debt low -- or at least stable?

The best growth companies have little or no debt. Those with debt less than 20 percent of long-term capital (equity plus long-term debt) shouldn't have any trouble financing their growth.

Do you believe the share price can double in five years?

A stock that meets all these tests should be able to double in price over five years. Stocks with earnings growth of 15 percent or more can reach that target if their P/Es stay constant and earnings come through as expected. Stocks with slower growth will need some increase in their P/Es, while stocks with much faster growth can afford to have their P/Es erode a bit. Whichever type of stock you favor, make sure that the growth and P/E numbers you're counting on aren't wildly out of line.  Top of page

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