In theory, no company should be able to show earnings increases that are way above average for very long. Whenever a market offers opportunities that can lead to rapid growth, those high profits attract more and more competitors. As these firms try to undercut each other, profit margins
-- and growth rates -- deteriorate.
Nonetheless, companies from Cisco to Pfizer to Wal-Mart manage to remain stars for years. They can do this in one of two ways -- either by maintaining a leading 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.
Since growing companies go after the most profitable markets first and eventually face tough competition, even the most dynamic businesses slow down sooner or later. So here are seven questions to help determine if a stock still has plenty of growth 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 more than 90 percent of desktop PCs, for example, Microsoft was virtually assured revenue for 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. Dell attracted an almost fanatical following of investors who believed that the company's direct-selling strategy would enable it to keep grabbing market share from competitors. But market share can't be increased indefinitely, and eventually Dell's sales growth failed to meet Wall Street's expectations.
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. Take IBM, which for decades led many major technological advances and was the must-own tech stock. But by the mid-1980s, the company fell behind in cutting-edge technology. IBM relied far too heavily on old-line mainframe computers and failed to adapt successfully to the PC era -- and its stock began a decade-long slide.
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 eventually, they can't afford to borrow any more. 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, based on the company's industry and its own history.
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