How to evaluate fastest growing companies? This article can shed some light about how to do it. We all want to buy a prospective ‘growth stock’, but we often end-up buying a wrong one. How to eliminate this miss? Read more about stocks with highest last 10Y returns.

[*Access a list of fastest growing companies at the bottom of this blog post.*]

What I want to explain here is the concept of “fast growth”. Why to know **the concept**? Because the way we search for fast growing companies is not a safe approach. Why I say so?

Because, to unearth a fast growing stock, we must look deeper. A superficial search will not highlight a truly fast growing company. Then, how to go about it?

### The Concept – Look Deeper

Suppose I ask you this question, *“which are the potentially fastest growing companies in India in 2019”*? How you will answer this question? Our first instinctive reaction will be to look at the historical prices.

For people who know more about stocks will see growth rates of sales, net profit, EPS, dividends, net worth, asset etc and make a guess. Read more about high EPS stocks & its growth rates.

The question is that, is this the right way?

The approach is not wrong, but a value investor would like to see deeper. Signs like sales growth, profit growth etc is only the tips of the iceberg.

What lies beneath is what’s making these metrics grow.

## How a business grows?

PAT, EPS, Dividend, Net Worth of a company cannot grow on its own. *It must be grown.* In order for the company to grow, it must *take actions*. What are those actions?

**Reinvestment of Retained Profit**: What are retained profits? Net Profit minus Dividend. It is that portion of net profit, which has not been paid to shareholders as dividends.*Cumulative*of all passing years retained profits are shown in companies balance sheet as “reserves”. Companies use its reserves fund growth. Read more about how companies use retained profits.**Making Company More Efficient**: Businesses utilise resources to generate profits. Companies which are efficient, generates more profits per unit resource utilised. Such efficient companies has a better chance to grow faster in future. Read more about profit margin of companies.

So lets sum up, how a company grows?

Company Growth = Growth due to (Reinvestment + Efficiency improvement)

Formula-1

## 1. How fast a company can grow?

Estimating future growth is like acting god. Why? Because future prediction is impossible.

No body can claim to know what will happen tomorrow. Neither Warren Buffett, nor you not anyone. But what can be done is this:

Estimate future growth based on business fundamentals of a company.

What does it mean? *Estimating* future growth based on business fundamentals is more maths than fortunetelling. I am sure, you will agree that mathematics is more reliable.

But maths will forecast high future growth only if the “business fundamentals” are good.

Which fundamentals will ensure fast growth? Like growth is a factor of reinvestment & efficiency, **speed of growth** also has an interrelation. It has follow two interrelations:

**How much is reinvested**: Out of the total profit that the company, a portion of its is paid to shareholders as dividends. The balance is retained by the company for reinvestment. The retained profit is called reserves. Out of these reserves, a portion is reinvested back into the company in form of CAPEX plans. The objective of CAPEX plans is to make the company grow.**How well it is reinvested**: Even if the company is reinvesting its reserves, more important is to get the final results. What is the final result? Enhancement of profit, and profitability of the company. If both these parameters are increasing, it is a sign that the reinvestment is being done well by the company.

Generally a fast growing company reinvests most of its profit back into the business. The result is that, its profit and profitability grows faster with time.

Which are the stock metrics which can tell us, how much is reinvested and how well it is reinvested? Please read further…

### 1. How much is reinvested:

In order to understand how much is getting reinvested, one can use the below two metrics.

**Retention Ratio**[(PAT-Dividend) / PAT ]: The higher is the retention ratio, means the company is giving out less as dividends, and retaining more profit for reinvestment. For such companies, the “reserves” in balance sheet grows faster.**Reinvestment Ratio**[(Net Capex+Change in WC) / {EBIT x (1-t)}]: How much is reinvested out of reserves is more important. How to know it? This can be known by calculating the reinvestment ratio.

Higher reserves also makes additional funds available for the company. How?

As reserves goes up, the company’s equity base becomes richer. This brings down the companies Debt/Equity ratio. Hence it becomes eligible for more loans. Which loans?

**Long term debt**: This will further increase the employed capital of the company. Companies can also use this extra fund to further boost its expansion and modernisation plans.**Short term debt**: This will also increase company’s current assets. Companies can use this fund for its business operations (working capital etc).

A company which has high retention ratio gets double benefits. One one hand it has more funds available for CAPEX. On other hand it can also borrow more from banks (loan) and further boost its liquidity.

### 2. How well profits are reinvested:

The objective of reinvestment should not only be to increase profit, but also to enhance efficiency. If the efficiency is growing with profit, it is a sign that reinvested work is being done well.

How to know if the efficiency is increasing or not? By looking at ROE and ROC history.

**ROE**(PAT / Book Value).**ROC**[ EBIT x (1-t) / (Equity+Debt-Cash).

[Read more on how to calculate ROE – Example.]

### 3. “First” Formula for speed of growth

A combination of retention / reinvestment ratio with ROE/ROC respectively will give this answer. Combination of the two formula will tell us about the speed of growth of a company.

Formula for growth in company due to reinvestment =

= Retention Ratio x ROE

Formula-2.1

= Reinvestment Ratio x ROC

Formula-2.2

What the above formulas signify? To grow, a company reinvests its profits back into the business. This reinvested money ensured future growth. How fast will be the growth?

There are are two ways to look at it. (a) A general observation – through retention ratio and ROE. (b) More specific observation – through reinvestment ratio and ROC.

**Retention Ratio * ROE**: talks about how much a company adds to its equity to generate extra profits.**Reinvestment Ratio * ROC**: talks about how much a company adds to its assets to generate extra profits.

One can use either of the above formula to estimate growth rate of company due to reinvestment.

Abbreviations used:

- PAT = Profit After Tax.
- CAPEX = Capital Expenditure.
- WC = Working Capital.
- EBIT = Profit Before Interest & Tax.
- t = Effective Tax Rate.
- ROE = Return on Equity.
- ROC = Return on Capital.

### 4. “Second” Formula for Speed of Growth

Suppose there is a company whose total asset is say Rs.100 Crore. This company generates PAT of Rs.10 Crore. What is its ROC? 10% (PAT/Asset).

[Total Capital (Equity + Debt) = Total Asset.]

Now, this company has target to improve its ROC from 10% to 12%. But it does not intend to grow though “reinvestment” route. What it can do to improve ROC? By cutting down on its cost. This way companies PAT will go up.

But this growth in PAT has happened without adding anything to its asset base (zero capital expenditure).

Here we can say that the company has been able to increase profit *by improving its efficiency*. Ideally, this is the best way to ensure growth. But such growth has **two major limitations**:

**One**: Only small companies, which has smaller ROE/ROC (say < 20%) can grow like this.**Second**: Companies cannot continue to grow its profit through efficiency improvement only. This can happen only till a limit

Beyond that, growth can only happen from reinvestment (by asset enhancement). What is the formula that can be used to quantify growth due to efficiency improvement?

Growth in company due to efficiency improvement =

= (ROE2 – ROE1) / ROE1

Formula_3.1

= (ROC2 – ROC1) / ROC1

Formula_3.2

So this brings us to our final conclusion. Total growth of a company can happen in two ways (both included).

- By reinvestment of its profit back into the business.
- By efficiency improvement.

This way the total growth formula comes out to be like this:

**Total Growth = Formula_2.1 + Formula_2.2 or**

**Total Growth = Formula_3.1 + Formula_3.2**

## Conclusion

Let’s conclude the topic of “companies growth”. Using ROC Formula, growth rate of a company is represented as:

**Total Growth = Reinvestment Ratio * ROC + (ROC2 – ROC1) / ROC1**

**Case-1: Company is not reinvesting**: If the company is not reinvesting its capital, CAPEX + Change in working capital is zero.Mens, its reinvestment ratio is zero. In this case, growth is totally dependent on efficiency improvement. Growth = (ROC2 – ROC1) / ROC1**Case-2 : Company is only reinvesting**: If the company is only reinvesting, its growth due to efficiency improvement will be zero. In this case growth is totally dependent on reinvestment. Growth = Reinvestment Ratio * ROC

What we can conclude from this article?

Companies which reinvest its money, and also has higher ROE / ROC is more likely to grow faster in future.

### Example of future growth estimation…

How to estimate future growth rate of a company? We can use the below two steps:

**Step #1. Pull out the numbers**: Which numbers to be obtained from the companies financial reports? We need to pull-out specific data from companies “profit and loss a/c” and from the “balance sheet”. The numbers that I am talking about are these:

**Step #2. Calculate**: Sample calculation is shown in below image. [P.Note: In row “ab” & “ac” which is Efficiency Growth (ROE/ROC), will be zero if the preceding years ROE/ROC is more than 0.20. Why? Because, I have assumed that a company which already has a high ROE/ROC, cannot grown more on basis of efficiency improvement. Such companies must reinvest for future growth. Total growth of such companies will be a factor of reinvestment.

In the above example, we have two total growth numbers: (a) Total Growth (ROE based), and (b) Total Growth (ROC based).

Which one to be referred? Frankly speaking, there are no preferences. The selection is totally based on the researcher’s judgement. I generally prefer ROC based total growth calculation. Why? Because it is based “net capital expenditure and change in working capital”.

What shall be the grown rate for the above example stock? For me a safe assumption for future growth rate will be **7.5%.** Why? The rationale behind this decision is shown below:

## List of fast growing companies (in Nifty 500 Index)

**Handpicked Articles:**

I’m not getting the same values as yours for reinvestment ratio with the formula mentioned.

Thanks a lot sir

Had this calculations included in worksheet

The stock analysis worksheet tries to estimate the future growth rate with lot more data. Yes, it includes the above method as well. Thanks for asking.