Method to Score Companies On Growth

Evaluating company growth is essential in direct stock investing. Fast-growing companies tend to offer higher returns and better investment opportunities. Why? Because such companies can expand their market share, innovate, and increase profitability. For example, a company with consistent revenue growth can reinvest profits into new projects. This fuels further expansion and creates more value for shareholders.

A strong EBITDA growth indicates efficient management and cost control. Investors look for companies that can sustain growth over the long term. This reduces risk and enhances portfolio stability.

By focusing on growth metrics, investors can identify companies with robust potential. This approach helps in building a strong portfolio consisting of quality stocks.

My Stock Engine algorithm scores companies based on their reported past growth numbers. It uses metrics like Revenue Growth, EBITDA Growth, Cash Flow Growth, etc to evaluate performance. This type of algorithm provides a clear, comprehensive view of each company’s growth potential.

Let’s read more about the Stock Engine’s growth algorithm.

Growth Algorithm - Stock Engine - Infographics

Topics:

1. Understanding The Growth Algorithm

The purpose of the algorithm is to identify companies with strong growth potential. It does this by analyzing past financial performance. The goal is to help the users of the Stock Engine app to get a perspective on the growth potential of companies.

The growth score is based on a company’s historical data. The Stock Engine’s algorithm uses the historical data to present a snapshot of its growth trajectory.

The algorithm evaluates several key metrics. These include Revenue Growth, EBITDA Growth, PAT Growth, EPS Growth, Net Worth Growth, Operating Cash Flow Growth, and Sustainable Growth Rate (SGR).

Each metric offers a unique insight into a company’s financial health and future prospects.

  • For instance, Revenue Growth shows how much a company’s sales have increased over time. Consistent revenue growth can indicate a strong market position and customer base.
  • EBITDA Growth measures earnings before interest, taxes, depreciation, and amortization. It reflects a company’s operating performance without accounting for non-operating factors. A high EBITDA growth rate suggests efficient management and profitability.
  • PAT Growth, or Profit After Tax Growth, indicates how well a company is generating profit after all expenses. This metric is crucial for understanding the overall profitability of a company.
  • EPS Growth measures the increase in earnings per share over time. It accounts for the impact of share dilution. Hence, it provides a clear picture of profit distribution among shareholders.
  • Net Worth Growth looks at the increase in a company’s equity. It reflects the company’s ability to generate and retain value.
  • Operating Cash Flow Growth evaluates the cash generated from core business activities. It shows how well a company can sustain operations and invest in growth.
  • Sustainable Growth Rate (SGR) measures the rate at which a company can grow without needing additional financing. It combines the return on equity and retention ratio, providing a balanced view of growth potential. Read more about it here.

By using these metrics, the algorithm provides a comprehensive score focused on the growth capability of the company. It can help users to identify the fastest-growing companies.

2. Key Metrics – Definition and Significance

Evaluating the growth of a company involves analyzing several key financial metrics. Each metric provides unique insights into different aspects of the company’s performance. Here, we will discuss the definitions and significance of these metrics.

Growth Algorithm - Stock Engine - Significance of growth parameters

2.1 Revenue Growth

Definition: Revenue Growth measures the increase in a company’s sales over a specific period.

Significance: It indicates the company’s ability to expand its market presence. Consistent revenue growth shows that the company is successfully attracting and retaining customers.

For instance, a welding electrode manufacturing company increasing its revenue year after year suggests strong demand for its products. It is also an indicator of rising market share.

2.2 EBITDA Growth

Definition: EBITDA Growth measures the increase in the company’s profit. EBITDA is a measure of the profit before interest, taxes, depreciation, and amortization.

Significance: This metric shows the company’s operational efficiency. High EBITDA growth means the company is good at controlling costs and generating profits from core operations.

For example, a manufacturing company with rising EBITDA might be improving its production processes leading to better efficiency.

2.3 PAT Growth

Definition: PAT is Profit After Tax. PAT growth measures the increase in net profit after all expenses and taxes have been deducted.

Significance: It indicates the company’s overall profitability. High PAT growth shows that the company is not only increasing its revenue but also managing its costs effectively.

For example, a retail chain with rising PAT suggests efficient cost management and robust sales growth.

2.4 EPS Growth

Definition: EPS is Earning Per Share (PAT per share). EPS growth measures the increase in earnings per share over a specified period. It indicates how much profit the company is generating per share.

Significance: This metric accounts for the impact of share dilution. It reflects how profit is distributed among shareholders.

For instance, a company issuing new shares but still showing EPS growth indicates strong profit generation. An improving EPS over time is a clear indicator of shareholder-friendly management.

2.5 Net Worth Growth

Definition: Net Worth (or book value) growth measures the increase in a company’s equity over time. A company’s net worth growth is directly linked to the company’s profit-generating potential. How much of the company’s profit is retained, accounts for the net worth growth.

Significance: This metric shows the company’s ability to generate and retain value. High net worth growth reflects strong financial health and the ability to reinvest profits effectively.

A company with a rising net worth is likely building a solid financial foundation. A fast-growing net worth base is an indicator of a self-reliant business. Such companies can grow fast without relying on external cash (debt).

2.6 Operating Cash Flow Growth

Definition: Operating Cash Flow Growth measures the increase in cash generated from core business activities.

Significance: It indicates the company’s ability to sustain its operations and fund growth initiatives.

For instance, a company with a growing operating cash flow is generating enough cash to invest in new projects without needing external financing.

A company whose PAT and Cash flow are growing at the same rate is a company that is not just reporting profits it is also collecting the said money (from customers). Often such companies have a relatively happier customer base.

2.7 Sustainable Growth Rate (SGR)

Definition: Sustainable Growth Rate (SGR) measures the rate at which a company can grow its sales, earnings, and dividends without needing to increase debt or equity.

Significance: It provides a balanced view of growth potential and financial stability. A high SGR means the company can grow organically at a steady pace. For example, a company with a high SGR is likely reinvesting profits wisely to fuel further growth.

Each metric contributes to a holistic evaluation, helping to identify the fastest-growing companies with strong future prospects.

3. Scoring Methodology

The algorithm uses a detailed scoring methodology to evaluate each company’s growth potential. This methodology ensures a comprehensive and accurate assessment. The results do not rely solely on the growth rate (CAGR) number.

As a long-term retail investor, our priority should also be on reliability and growth consistency. Hence, my algorithm also scores companies based on their age and growth consistency.

3.1 Consistency

Consistency measures the steadiness of a company’s growth over time. A company that shows consistent growth year after year is more reliable.

Consistency is measured by checking if a metric, like revenue or profit, has increased every year for the past five years.

For example, a company with revenue growth every year will score higher on consistency.

A consistent growth pattern indicates that the company can sustain its performance even during market fluctuations.

3.2 Growth Rate (CAGR)

The Compound Annual Growth Rate (CAGR) measures the rate of growth over a specific period. It provides a smoothed annual growth rate, eliminating the impact of volatility.

Companies are scored based on the quantum of their growth rate. For instance, a company with a CAGR above 35% might score 5 points, while one with a CAGR between 35% and 30% might score 4 points.

Higher growth rates indicate that the company is rapidly expanding, which is a positive sign for future growth potential.

For example, a Fintech startup with a CAGR of 42% shows rapid market penetration.

3.3 Years of Operation

The number of years a company has been in operation is crucial for its score. Companies with a longer operational history have demonstrated their ability to survive and grow. The algorithm awards higher scores to companies with more years of consistent data.

For example, a company with 10 years of continuous operation and growth will score higher than a company with only 3 years of data.

This approach ensures that the assessment favors companies with proven track records.

3.4 Weighted Average Method

The weighted average method combines the scores from all metrics to provide a final growth score.

Each metric is assigned a weight based on its importance. For instance, revenue growth might have a higher weight compared to net worth growth. It is a reflection that revenue has a more critical role in assessing company performance.

The rationale behind this weighting is to emphasize metrics that more significantly impact a company’s growth potential.

For example, higher weights might be given to EBITDA growth and revenue growth because they directly reflect operational performance and market expansion. This method ensures a balanced and comprehensive assessment, taking into account multiple dimensions of growth.

A company is first scored based on each growth metric explained above. These metrics are evaluated not only on CAGR but also on the consistency of the reported number and the age of the company.

The next step is to combine each metric based on a weighted average multiple. This type of algorithm provides a robust and accurate score to its companies.

The system helps investors identify the most promising companies with strong growth potential. The algorithm offers a clear and data-driven analysis of companies.

4. Case Study (Hypothetical Example)

To illustrate how the algorithm scores companies, let’s analyze a hypothetical Indian company, ABC Ltd. We will use its 5-year data for Revenue, EBITDA, PAT, EPS, Net Worth, Net Cash Flow from Operations, and Sustainable Growth Rate (SGR). This will help in calculating its growth score on a scale of 0 to 6.

Assumed Data for ABC Ltd. (in INR crores):

  • Revenue: 500, 600, 720, 850, 1000
  • EBITDA: 50, 60, 72, 85, 118
  • PAT: 20, 25, 30, 40, 61
  • EPS: 2, 2.5, 3, 4, 6.1
  • Net Worth: 200, 225, 250, 300, 400
  • Net Cash Flow from Operations: 30, 40, 50, 60, 75
  • SGR: 10%, 12%, 9%, 11%, 12%

4.1 Years of Operation:

ABC Ltd. has a full five years of data. This indicates a stable operational history and earns the highest score of 5 points.

4.2 Consistency:

ABC Ltd. has shown consistent growth across all metrics over the past five years. Each metric has increased every year without any decline. This consistency scores high, showing reliability.

Consistent revenue and profit growth indicate a stable business model. Thus, the company scores 5 points for consistency.

To make the matter even more desirable for the shareholders, the company (ABC Ltd) has also assured that the EPS keeps growing at an acceptable rate.

4.3 Growth Rate (CAGR):

Calculating CAGR for each metric:

  • Revenue Growth: CAGR = 14.86%
  • EBITDA Growth: CAGR = 18.90%
  • PAT Growth: CAGR = 25.00%
  • EPS Growth: CAGR = 25.00%
  • Net Worth Growth: CAGR = 14.86%
  • Net Cash Flow from Operations Growth: CAGR = 20.11%
  • SGR: 10.8% Average.

Now, our scoring algorithm will give a score considering all three factors, age, consistency, and growth rate. Just for example, let’s assume that the company ABC Ltd obtains the below scores:

  • Revenue, EBITDA, SGR: Score 3 points each (15%-20% range).
  • Cash Flow: Score 4 points (>20% range).
  • PAT, EPS: Score 5 points each (>25% range).
  • Net Worth: Scores 2 points (10%-15% range).

4.4 Weighted Average Method:

Let’s assume that the average weights (importance) given to each metric from the perspective of growth scrutiny are as below:

  • Revenue: 20%
  • EBITDA: 15%
  • PAT: 15%
  • EPS: 15%
  • Net Worth: 10%
  • Cash Flow: 15%
  • SGR: 10%

Hence, the weighted average score comes out as:

  • Revenue: 3 * 0.20 = 0.60
  • EBITDA: 3 * 0.15 = 0.45
  • PAT: 5 * 0.15 = 0.75
  • EPS: 5 * 0.15 = 0.75
  • Net Worth: 2 * 0.10 = 0.20
  • Cash Flow: 4 * 0.15 = 0.75
  • SGR: 3 * 0.10 = 0.30

Total Weighted Score = 3.80 out of a total of 5.

Final Score:

Including the points for consistency and years of operation, the final score earned by ABC Ltd. is 3.8. Similarly, let’s assume that we have two more companies that earn a score of 4.2 and 2.2 respectively.

At this stage, the Stock Engine algorithm thinks that if these scores are normalized on a scale of 0 to 100, it results will become more interpretable. The Stock Engine calls it GMR Score (for Growth).

Hence, the normalized score of the three companies will look like this:

  • Company 1 (ABC Ltd): 3.8 / 4.2 * 100 = 90.47%
  • Company 2: 4.2 / 4.2 * 100 = 100%
  • Company 3: 2.2 / 4.2 * 100 = 52.38%

This method shows how the algorithm evaluates and scores companies comprehensively, helping investors identify promising growth stocks.

5. Results and Insights

Applying the algorithm to a wide range of companies has provided valuable insights.

High-scoring companies generally show consistent growth across all key metrics. They have strong revenue growth, and robust EBITDA figures. It was also encouraging to note that such companies not only grew their PAT but also their EPS. They also made sure that their “net cash flow from operations” keeps pace with the revenue and PAT growth rates.

Additionally, these companies display solid net worth growth ensuring self-financed growth rather than debt-induced growth.

What data trends show:

  • High-scoring companies often share several key characteristics. They usually operate in sectors with high demand and strong market positions. These companies are adept at managing costs, which is reflected in their EBITDA growth.
  • They also have a solid track record of reinvesting profits (leading to net worth growth). They not only reinvest but also make sure that it is done wisely as reflected by their high ROE and ROCE numbers.
  • Companies with high scores often prioritize innovation and market expansion, which drives revenue and PAT growth.
  • They maintain strong cash flows from operations, indicating efficient management and operational excellence.

In essence, high-scoring companies are well-rounded, with balanced growth across multiple financial dimensions.

Conclusion

We’ve explored a comprehensive method to score companies based on their growth potential. By using key financial metrics like Revenue, EBITDA, PAT, EPS, Net Worth, Operating Cash Flow, and SGR, the algorithm provides a detailed growth score.

This score helps investors identify the fastest-growing companies with strong future prospects.

The value of the algorithm lies in its ability to analyze multiple dimensions of growth. It offers a balanced and thorough evaluation, helping investors make informed decisions.

Looking ahead, the algorithm can be enhanced by incorporating additional metrics like market share growth and R&D investment. These factors can provide deeper insights into a company’s competitive edge and innovation capabilities.

Additionally, integrating real-time data and advanced analytics can improve the accuracy and relevance of the scores.

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Disclaimer: The information provided in my articles and products are for informational purposes only and should not be considered as financial or investment advice. Read more.

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