Analyzing Growth Rates

Much of financial analysis is focused on determining a company’s financial strength or weakness, how profitable the firm is and how well management uses assets and debt. However, there is another important component: growth. Specifically, this analysis focuses on determining whether a company is growing sales, earnings and cash flow and the likelihood of it continuing to do so in the future. As part of my series on financial statement analysis, this article delves into growth rates and discusses how you can use them not only to evaluate a company’s financial strength but also to make an educated guess as to how a company will perform going forward.

Calculating Growth

Growth measures a company’s sales, earnings or cash flow at one point in time compared to a point in time in the past. Growth can be analyzed for various time ranges, though analysts typically look at periods ranging from the past 12 months (often times referred to as trailing 12 months, or TTM) up to the past five or seven years.

Calculating total growth is straightforward: You simply subtract the beginning value of a financial figure from its ending value, and then divide that result by the beginning value. Annualized growth shows the average growth rate experienced over a specified time period (e.g., seven years). Annualized growth is also referred to as compound growth; the calculation is presented in the box below. You can estimate annualized return, however, by simply dividing total growth by the number of periods. This estimate works well for off-the-cuff analysis, but it does not accurately reveal the impact of fluctuations in growth or compounding.

With this said, it is almost never necessary to calculate growth rates manually because they are easily obtained from investment websites and software programs. For example, AAII’s Stock Investor Pro fundamental stock screening and research database program provides growth rates for one-, three-, five- and seven-year periods for each of the data elements discussed here. The top comprehensive investment websites also offer similar data (these sites can be found in AAII’s Guide to the Top Websites at www.aaii.com/guide/webguide).

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