The Importance of Revenue Growth in Stock Investing

Revenue Growth in Stock Investing

A company’s expected revenue growth is one of the most important factors investors use in determining the potential future stock price of that company.

The value of common stocks is, of course, closely tied to the earnings power of the company, so an understanding of the company’s growth potential for both the near and long-term timeframes is required in making a sound investment decision.

Growth rate calculations are especially important for start-up companies which may currently have very little net income but an expectation of high future growth rates.

Why is Revenue Growth Important?

Revenue is simply the amount of money that the company receives during a specified time. The revenue calculation is the number of goods or services sold during that period multiplied by the price. The result is referred to as the “top line” or “gross income” figure. It is from that figure that costs are then subtracted to arrive at net income.

Revenue growth is often seen as more valuable than the growth in net income because net income can increase with cost-cutting measures. While there are limitations on the extent to which costs can be cut there is – theoretically- no limit to the amount by which revenues can increase.

Revenue Growth Rate – Looking at Historical Revenues

The trick for investors is in predicting future revenues. The use of the company’s historical growth rates is a simple method for estimating future growth. Looking at these numbers can help investors to become familiar with this baseline of the company’s historical performance.

Many investors start by looking at the 5-year revenue growth. The formula for this can be written as:

5 Year Revenue Growth = (Year 5 Revenue – Year 1 Revenue)/Year 1 Revenue

Using this formula, the investor can then build a table to analyze revenues over recent years, often breaking these revenues out by company business segment. A CAGR (Compound Annual Growth Rate) calculation can then be used to annualized these growth rates.

Growth Stocks for 2021

Top 10 Growth Stocks for April 2021

A list of 10 suggested growth stocks based on 3-years sales Growth CAGR.

CAGR = compound annual growth rate. 

TOP 10 Growth Technology Stocks – 2021

* Quarterly Revenue Growth Year over Year %:greater than 25

Advanced Micro Devices, Inc.AMD
NVIDIA CorporationNVDA
21Vianet Group, Inc.VNET
Adobe Inc.ADBE
Daqo New Energy Corp.DQ
Skyworks Solutions, Inc.SWKS
ASE Technology Holding Co., Ltd.ASX
Inseego Corp.INSG
Zscaler, Inc.ZS

Formula to Calculate Compound Annual Growth Rate

Formula and Calculation of CAGR

Analyzing Other Factors

Of course the historical rates don’t always apply to future performance as both competitive and economic conditions tend to change over time. Savvy investors will also look at the company’s profit margins and other elements of the balance sheet to find problems that might be covered up by growing revenues.

Growth Stock Investing

Generally speaking, a strategy employed by an investor selecting stocks with above-average increasing potential is considered growth stock investing. These targeted stocks are corporate assets whose quarterly earnings are anticipated to grow relatively quickly in comparison to the overall market within its particular industry.

Often termed as a capital growing strategy by investors, maximizing capital gains is the overall goal. Though many say investing is diametrically opposed to value investing, it\’s more appropriate to accept the two strategies in light of a Warren Buffet quote, where he talked about increasing as well as value investing being tightly joined.

Similarly, another investing mogul by the name of Peter Lynch is credited with first implementing an intermediate approach between the two, commonly spoken of as the GARP strategy, or growth at reasonable prices.

what is revenue growth in stocks

Growth Investing Returns for Investors

By the end of the 1990\’s, during the big tech stock boom, those employing growth investing tactics yielded extraordinary returns for investors.

It should be noted, however, that increasing stock investing has some substantial risks. This method is not for the faint of heart, and it\’s potential gains and losses should be well understood prior to making any such leap.

Perhaps the easiest way to illustrate exactly what growing investing is to show what it isn’t as compared to its counterpart, value investing. The value investor takes into account current expectations.

Those stocks trading below their perceived value are considered value purchases, on the speculation they will return to their true value in the short term.

In contrast, growing investors buy shares of companies that are expected to balloon from their current value over a considerably greater length of time, with little concern about the stocks’ current pricing.

In this type of trading, buying at levels above the perceived worth of the stock can and does occur. The strategy is reliant on the potential for the overall growth of that company in the future.

Those stocks that are considered growing stocks are shares of companies speculated to grow relatively quicker than other similar interests. It stands to reason that younger companies are of a higher interest to growing investors.

This takes into consideration the theory that earnings and revenue emerging will translate directly to an increased share price for the stock.

Those industries expected to increase rapidly in their asset value are good candidates, most especially one’s leading in new technologies.

Capital gains are the means of realizing profits here, not dividends, as more often than not these types of ventures are prone to earnings reinvestment leaving very little for dividend pay-outs.

A major player in teaching and utilizing growing stock investing strategies is The National Assn of Investors Corp. or NAIC. They have a five-point checklist to assess emerging stock candidacy. All five requirements should be met to consider the stock a prime option.

These are the five points in paraphrase:

  • Does the stock historically show strong earnings?
  • Is strong growth expected going forward?
  • Is the management of the company effective in controlling revenues and costs?
  • Does the management show signs of continual improvement and innovation?
  • Does it seem likely that the price of stock can double within the next five years?

Following these guidelines, and an affirmative answer to all of them will provide a stock that is likely a good candidate for stock investing.

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Growth Investing and Small-Cap Stocks

Small-Cap stocks (stocks with small market capitalization) are generally defined as companies with a market capitalization of between $300 million and $2 billion (although the small-cap classification can vary among brokerage houses).

While these securities trade with higher risk profiles than larger-caps, they can offer greater upside potential and may be appealing to investors who can tolerate the volatility.

What is Market Cap?

 A company’s market capitalization or “market cap” is its total dollar market value of all of its outstanding shares. The market cap is determined by multiplying the stock price by the total number of outstanding shares. This gives you the total value of the company on the open market.

For example, if a company has 20 million shares outstanding, with a stock of $100, the company’s market capitalization is $2 billion. 

CategoryMarket Capitalization
Micro-cap companiesLess than $300 million
Small-cap companies$300 million to $2 billion
Mid-cap companies$2 billion to $10 billion
Large-cap companies$10 billion to $200 billion
Megacap companiesMore than $200 billion

In evaluating a company as an investment, the market cap should be considered as it can have an impact on both the potential risk and return of the investment. The various market caps are divided as follows:

What is Micro-Cap Growth Stocks?

A micro-cap-stock is a stock with a very small market capitalization, typically between $50 million and $500 million. Micro-cap stock companies are considered extremely volatile, primarily since the price of a micro-cap stock can be substantially influenced by a single large trade.

These investments can be difficult to liquidate due to low trading volume. For these reasons, due diligence is extremely important when considering micro-cap stocks. While these stocks often come under fire for their volatility; recent history shows that they can yield the best returns.

What is Small-Cap Growth Stocks?

A small-cap stock will typically have a market capitalization of between $300 million and $2 billion. Part of the attraction of small-cap stocks is that it is easier for these smaller companies to double their sales than it is for very large companies. This, of course, can lead to greater capital gains.

In fact, on an annualized basis, small-cap stocks have outperformed large-cap stocks by almost 2.5 points over the past 80 years. Like micro-caps though, they carry a higher risk of market fluctuations.

What is Mid-Cap Growth Stocks?

A company with a market capitalization between $2 billion and $10 billion is considered to be a mid-cap stock. A mid-cap company is in the middle between large-cap and small-cap companies. For many investors, mid-cap stocks are good investment options because of their potential for upside price appreciation with less volatility than the smaller caps.

These companies are often well-positioned for growth and have demonstrated resilience to the challenges of the market. These companies have usually had a chance to put solid a management team in place with well-defined product offerings and messaging.

What is Large-Cap Growth Stocks?

A large-cap stock has a market capitalization of more than $10 billion. These are the biggest and most well-established companies in the world. Large-cap stocks tend to be well-established and operate with less uncertainty than the smaller cap companies. While they are typically less risky investments, they usually have slower growth than smaller companies.

Many large-cap stocks are income-producing for the investor through steady and consistent dividend payments. A company’s market capitalization, often called a market cap, can be obtained by multiplying the number of outstanding shares (number of shares the company has issued) by the price of the stock.

Companies are often labeled by the size of their market cap.

A company with a market cap over 5 billion dollars is called a large-cap, one with a cap between 500 million and 5 billion is referred to as a mid-cap, one with a cap between 150 and 500 million is called a small-cap and one with a cap below 150 million is labeled a micro-cap.

Even though a label may not seem important, a company’s market cap often affects its stock price dramatically. Also, when a company wants to acquire another public company it has to pay for its “market cap” and add a premium to appease stockholders and management.

When a fund manager researches for stocks to invest capital in he is usually restricted by the company’s market cap. Because most fund managers direct funds who concentrate on large caps, stocks with relatively small market caps are usually left out from a manager’s purchase list.

Stocks bought by fund managers usually get an artificial lift because of the large amounts of stock bought by them. Besides, investors sometimes use fund ownership as a critical criterion for buying a stock.

Another effect of a company’s market cap can be seen in today’s volatile market. Companies with large market caps and established leaders such as McDonald’s, GE, IBM have been left in a better position than those technology stocks whose market caps were smaller and leadership was untested. Such companies have lost more than half of their value as investors flock to “old economy” stocks.

Although a company’s market cap is but a number, its implications are widespread. When buying a stock you should make sure that the company has a market cap that fits with your investment strategy. A person who is investing for a conservative cause should not buy stock with Microcaps because of their inherent risk.

The Appeal of Small-Cap Stocks

The most compelling thing about small-cap investing is the potential for higher growth rates than larger, more mature companies might offer. For the small-cap investor, the goal is in finding small, relatively unknown companies that are bound for greatness. As these companies grow and thrive, their stock prices can see tremendous increases.

While smaller companies often “fly under the radar” and escape widespread scrutiny they are typically nimble and able to react quickly to market changes and competitive pressures. Small companies tend to be able to exploit opportunities that larger companies can’t respond to in a timely fashion.

Small-cap stocks often present growth investment opportunities due to their low valuations and potential to develop into larger-cap stocks over time.

Investment Criteria

The criteria for finding small-cap winners can include:

  • Strong Balance Sheet with significant cash reserves;
  • Solid expected earnings growth: many investors look for 30% or more;
    • A reasonable P/E ratio: many investors look for less than 20;
  • A debt-to-equity ratio of, ideally, less than .5;
  • Minimal analyst coverage.

A Word of Caution for Small-Cap Investors

Small-cap investing does come with a number of cautions though as these stocks offer less liquidity than larger-caps. They are also more susceptible to economic downturns and the threat of competition from larger companies that may choose to compete with them.

Investors should also keep in mind that a small company’s growth rate can slow as the company gets larger or as its marketplace becomes more crowded. When this happens, investors can expect the stock price of the company’s stock to fall.