Is it always profitable to invest in fast growing companies?

Market wisdom tells us that the value of a stock rises or falls depending on how well a company manages to grow its business.

The higher the growth, the greater the potential for its stock price to increase.

But when a company grows too fast, the risk of failure also goes up, which causes its value to fall.

While growth in general can be a good thing, too much growth can also be problematic, if not properly managed.

So how do you know if a company is getting too ambitious with its growth plans?

One way to determine how fast a company should grow is to compute for its sustainable growth rate or SGR.

The SGR is the maximum rate of growth that a company can sustain using its existing financial resources, without having to increase its debt or equity.

The SGR can be calculated by simply multiplying the return on equity or ROE by a company’s plowback ratio.

The ROE measures the ability of a company to generate profits from its shareholders’ investments, while the plowback ratio measures the earnings that have been retained to expand the business.

For example, Meralco, a mature company with stable earnings, generated a high ROE last year at 28 percent, but paid the bulk of its earnings, about 66 percent, as dividends to its stockholders.

Because only 34 percent of the earnings is reinvested into the business, the SGR of Meralco works out to be at 9.5 percent.

To validate how Meralco has performed this year, we can see that the actual growth of the company for the first six months was in line with its SGR estimate of 9.6 percent.

Now, the actual growth of a company may also fall behind or exceed its SGR.

If the actual growth is smaller than SGR, it may mean the company is anticipating bigger growth in the future.

For example, a growth company like Shakey’s Pizza, which had a ROE of 18.4 percent last year, distributed only 18.2 percent of its earnings as dividends.

Because it retained 81.8 percent of its earnings for reinvestments, we can expect the company to grow at a maximum rate of 15 percent given the same capital structure.

But with an actual growth of only 4.4 percent so far this year for the first six months, we can say that Shakey’s ongoing expansions have yet to pay off in the future, indicating tremendous growth opportunities.

If the actual growth exceeds the SGR, on the other hand, it may mean that a company is overextending its financial leverage and resources to support its growth, which may not be sustainable.

Excessive growth may also lead to higher risk of financial distress unless the company invests in new assets by borrowing more or selling additional equity.

Interestingly, if we will examine the SGRs of PSE index stocks last year, we will find that those with aggressive sales growth have lower P/E multiples compared to those with moderate growth.

For example, the PSE index stocks that reported with an average sales growth of 19 percent last year have lower average P/E multiples of 15 times, as opposed to those that registered a 5.3-percent growth which have average P/E of 21 times.

Why is this so? This is because those PSE index stocks with higher growth exceeded their average SGRs of 5.9 percent, while those with lower growth fell within their average SGRs of 10 percent.

Using the same historical information, we can also find that the excess growth of the actual rate over the SGR of PSE index stocks is negatively correlated with their P/E ratios in about 11 percent of the time.

This means that the further the growth of a company exceeds its SGR, the greater the tendency for its stock price to fall.

Fast growing companies may be exciting stocks to invest in, but if they don’t manage their growth well, their rapid success can lead to losses.

Investing in companies with promising growth prospects is good, but companies with a long-term sustainable growth is much better.