Once a company reaches a certain size, it typically becomes more difficult to maintain a far above average growth rate. So for large, more mature companies, consistency of growth eventually can become more important to traders than the sheer size of annual growth. This is why the historical growth rate is only one factor that traders should consider.
Components of historical growth
The term “historical growth” refers to the annualized rate at which a company has grown its earnings per share over a given period of time. For example, if a company reported earnings per share for this year of $2.48 per share, versus $1.00 per share five years ago, this works out to an average annual earnings growth rate of 20% per year. So the company could be said to have shown a 5-year historical growth rate of +20%.
The same calculation can be made over a 1-year, 2-year or 10-year basis, but five years represents a fairly standard analysis period as it covers a number of recent years of operations.
What traders look for
Generally speaking, the higher the historical growth rate a company achieves the better. Some historical research has shown a strong tendency for top performing stocks to show well above average historical growth rates prior to making their big run. This makes intuitive sense that traders would reward the top performing companies with a sharply higher stock price.
On the other hand, most companies can only sustain a far above average growth rate for a certain period of time. This is one reason that many growth-oriented traders tend to focus on smaller companies. Smaller companies typically have more room to grow early on. It is not uncommon for new, up and coming companies to post spectacular growth rates of 30% to 100% or more over a period of time.
What traders look out for
The “good news” regarding strong historical growth is that above average growth is almost invariably reflected by a higher stock price over time. The “bad news” is that no company will grow its earnings 100% per year indefinitely. At some point growth will slow. Though the growth rate may still be strong, anytime a company’s rate of growth demonstrably slows, there is a danger that the stock price will suffer.
So while a trader may be profitable owning a high growth stock, “once the music stops”, or even slows, the stock price may adjust to a lower level quite abruptly.
The primary job of all "for-profit" companies is to earn a profit. The size of a company’s annual profit is reflected in its stated earnings per share. The companies that grow their earnings per share at the highest rate over a period of time are essentially the “rock stars” of business performance. Invariably, this type of performance is reflected in a higher stock price.
With the aforementioned caveat that nothing lasts forever, a strong historical growth rate can be an extremely useful filter for identifying potential candidates. A company’s growth rate not only tells you in hard numbers how a company has performed but also how well it has performed relative to other companies, which makes this a valuable piece of information.