Companies grow at various rates and the growth of a particular company can change over time. Newer and younger companies tend to grow at faster-than-average rates, but there are many examples of large companies achieving extended periods of premium growth.

The direction of growth is important, since the stocks of rising growth companies tend to perform well and falling growth company stocks perform poorly. Identifying the early signs of a change in the direction of the growth rate of the company is critical to making a successful investment decision about the stock.

Growth can be difficult to measure. Ideally we should want to measure the rate of growth of corporate wealth generated for shareholders. Unfortunately the accounting data does not give us a clear indication of that. Earnings growth is often distorted by changes in the structure of the company, which result in the realization of gains or losses that were incurred in earlier years but not booked. That overstates the company’s growth in the earlier years and distorts it once the gain or loss is recognized on the books. In recent years, widespread corporate restructuring and several major changes in accepted accounting practices have resulted in a large number of unusual charges to earnings. That has rendered earnings a very bad measure of growth.

The first and most reliable measure of growth is the rate of sales growth. The effects of acquisitions or divestitures of other companies, or parts of other companies, frequently distort even this measure.

Sales growth is also very volatile. Even with seasonal effects removed, it is not unusual for sales growth to vary widely cross companies and also over time. None-the-less, the only long-term driver of growth is the rate of sales growth.  All other influences are temporary.

The other influences on the rate of growth of a company are the direction of the margin and the direction of costs.

The measure of growth that evolves from these data is earnings before depreciation and taxes. Since depreciation is a cost that does not effect the cash wealth of the company, it is not relevant to our measure of shareholder wealth. Since taxes are incurred uniformly across companies, they are often distorted by accounting policy changes and frequently do not involve cash.  We also exclude them from the shareholder wealth total. That leaves us with a shareholder wealth measure called earnings before depreciation and taxes or EBITDA. We modify that measure further by excluding interest costs. By measuring the rate of growth of the company before financing decisions, it is easier for us to judge the financial condition of the company, and whether management is making financing decisions that are in the interests of the shareholders. That leaves Earnings Before Taxes, Interest, Depreciation and Amortization  (EBITDA) as our most reliable measure of the growth in the wealth of the company. The EBITDA margin is the ratio of EBITDA to sales.  If the EBITDA margin is rising, with all else equal, the company growth rate is rising.

Sales Growth and costs will have varying effects on the rate of growth of the company depending on their proportion. The proportion of fixed vs. variable costs determines leverage. Leverage is a measurement of sales elasticity. If EBITDA growth rises or falls at a more rapid rate than sales then the company is leveraged. As sales increase the high fixed costs fall as a proportion of sales producing a more rapid increase in EBITDA. Unfortunately as sales fall, EBITDA falls at a more rapid rate. Since leverage cuts both to the positive and negative, highly leveraged companies are often considered more risky.

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