Consider a company's growth rate before investing

A major aspect of individual stock analysis within your investment portfolio is the evaluation of a company's growth rate. You should know a company's growth rate over the long term before you decide on investing.

Some investors prefer to emphasize growth stocks — shares of companies whose earnings are expected to rise significantly faster than the general economy. Because investors cherish such companies, their shares often carry premium valuations.

For example, take two companies, Company A and Company B, each of which is expected to earn $2 a share next year. For Company A, however, $2 is 25 percent more than it earned last year, and similar advances appear sustainable for the foreseeable future. For Company B, $2 represents a 5 percent increase over the last year and no more than 10 percent increases are projected for the next two years. In such a scenario, the shares of Company A, the growth stock, may be priced at $40 (or 20 times the estimated earnings for the year ahead), while the stock of Company B may be $26 (a price/earnings multiple of 13).

Owning growth stocks can lead to large gains for investors. If a year later Company A's shares are still selling at 20 times the expected earnings for the year ahead, the earnings multiple could be based on per-share earnings of $2.50, rather than the $2 from the prior year. This would result in a stock price of $50, or a 25 percent rise in one year's time.

Meanwhile, if Company B's stock is selling at 13 times projected earnings of $2.20, its share price would only be $28.60. Of course, growth stocks' premium valuations make their shares more vulnerable to sharp declines, especially if earnings are disappointing.

When evaluating a company's growth rate, you need to look at the company's performance over an extended period. A company may have improved its earnings in the past year, but its historical rate of growth may still lag. A company that can sustain an above-average growth rate over a significant period represents a sound investment opportunity.

The reason I take that position is because I believe that investors should seek out companies that consistently outperform the "average" company. Doing so enables investors to find opportunities that will also be above "average." In the end, that's what all investors are looking for: companies to invest in that will outperform most other companies, producing better-than-average returns. Every investor is looking for the goose that will lay a golden egg.

Having said that, what must an investor do to identify companies with "above average" growth rates? What is the "average" growth rate for a particular industry? And what is the growth rate of an individual company within that industry?

This information is crucial if you are going to evaluate the relative growth rates of different companies. Where do you find such information? If you look at the stock tables in your local newspaper or the financial press (Wall Street Journal, Investor's Business Daily), the best you are likely to get is a company's price/earnings ratio.

Investor's Business Daily provides information on a company's "relative earnings growth." This compares the growth rate of all of the companies in their database (over the preceding five years), and ranks them on a scale of 1 to 99, with 99 being the best. The problem with this measure is that it doesn't compare companies within one industry; it compares all companies.

Obviously, a technology company, if it is successful, will have a higher growth rate than say, a stationery company. You're comparing apples to oranges. If earnings growth were measured on an industry-by-industry basis, this would be an extremely valuable piece of information. As it is, it's useful, but only marginally so. So how does one go about obtaining this vital information? Unfortunately, growth rate information is not easy to come by. You can contact an individual company's investor relations department and request this information. Most large corporations will accommodate such a request, although you may have to wait a while to obtain the information. If you want to obtain the information by yourself, the outlook is not rosy.

The Standard &Poor's "stock guide" provides earnings information on most major companies over the past five years, but not growth rates. You must calculate a company's growth rate by yourself, using the information in the stock guide.

The way you would calculate a company's growth rate is to compare its earnings per share (EPS) at the beginning of the five-year period covered in the stock guide to the EPS at the end of the five-year period. The growth rate is the EPS at the end of the period minus the EPS at the beginning of the period, divided by four (the number of years from start to finish).

As you can see, this can be quite tedious. And you've only looked at four years' worth of earnings for one company. To develop meaningful investment information concerning a company's growth rate, you should look at the past 10 years.

When you are finished, you should then compare the growth rate of the company you are considering with the growth rate of its competitors. If the company you are considering is outperforming its peers, it may be a good investment candidate. The problem is that if you want to go back 10 years, you will need the current issue of the Stock Guide as well as the ones issued five and 10 years ago. Standard &Poor's, located at 25 Broadway, New York, N.Y., 10004, will sell you the guides you need, but as you can see, this is a time-consuming process.

A faster way to develop similar information is to use automated data processing tools. One such tool is Compustat PC Plus. This is a software product developed by Standard &Poor's, which describes it as a "Windows 95 software application for screening and generating reports from our financial databases."

With Compustat PC Plus, you can access data files including Standard &Poor's Stock Reports, EDGAR, Business Descriptions, Country Overviews and Trends &Projections. This is not the only software product on the market that will enable you to calculate a company's growth rate, but it is highly regarded by many investment professionals, including James O'Shaughnessy, the author of "What Works on Wall Street."

An analyst with Compustat PC Plus told me, "You can ask the program to identify all companies of a particular size — say those with a market capitalization of $1 billion to $2 billion — that have a growth rate in excess of 20 percent over the past 10 years, and the software will generate a list of companies that meet this criterion."

Of course, I do not know how easy it is to work with this particular software product, but if past experience is any indicator, I would expect to encounter a "learning curve" with any software product.

Another company offering purportedly similar software is Zacks Investment Research, which can be found at www.Zacks.com.

I recommend that you consult an expert in computer software to identify software programs that can satisfy your investment needs.

— Zall is a free-lance writer based in Silver Spring, Md., who specializes in taxes, investments and business issues. He is a certified internal auditor and a registered investment adviser. He can be reached via e-mail at miltzall@starpower.net.