3 Metrics that Really Matter in Growth Stock Analysis
Traditional value investing metrics like P/E or P/B are not the best choice when trying to find the best growth stocks. What I look at instead.
If you have been following this Substack for a while, you will know that different financial metrics play an important role when analyzing growth companies than in traditional value investing.
For example, instead of looking at the P/E ratio (Price/Earnings) and/or the P/B ratio (Price/Book Value), for growth stocks it makes more sense to look at the Rule-of-40 or the EV/Sales ratio (explained simply here). If you are new to these topics, I recommend you read the following 3 articles on the basics of my High-Growth-Investing strategy:
High-Growth-Investing 101 - Everything you Need to Know to get Started
When is the right time to exit a stock? - The Tenbagger Opportunity and how to Deal with Book Losses
The Rule of 40 - A Better Alternative to Value Growth Stocks
Today, I would like to introduce you to some other key metrics that I find very helpful in understanding the business model of growth companies and ultimately in assessing the potential of a stock.
1. Free Cash Flow per Share
When analyzing a company's profitability, I and many other professional investors consider the development of cash flow to be much more important than net profit. This is because the latter can be much more easily "shaped" - i.e. manipulated - by management using creative accounting techniques.
From an investor's point of view, however, cash flow development should always be considered in the light of dilution. This is because the growth of a high-growth company is often bought at a high price by issuing new shares. This effect is eliminated in the cash flow calculation by analyzing the development of the cash flow per share instead of the absolute cash flow.
What is Free Cash Flow per share?
Free Cash Flow per share (FCF per share) shows how much Free Cash Flow (FCF) each individual share of a public company is entitled to. As a reminder, Free Cash Flow is the amount of money that a company has generated after paying operating costs and deducting any investment in fixed assets (such as plant or equipment). It can be used to pay dividends to shareholders, reduce debt, fund share buybacks or invest in future growth.
Free Cash Flow per share is calculated by dividing the company's total Free Cash Flow by the number of shares outstanding:
FCF per share = Total Free Cash Flow / Number of outstanding shares
This ratio is particularly useful in assessing a company's ability to create value for shareholders. A sustained increase in FCF per share generally indicates that a company is financially sound and able to meet its obligations over the long term. It can also be used as a benchmark to compare companies within the same industry or to assess a company's profitability and stability over time.
For me, FCF per share, and its growth rate, is also the key metric when it comes to assessing whether SBC (Share-Based Compensation) should be viewed negatively for a growth company. I have discussed this topic in detail in a previous article: What You as a Shareholder Should Know About Stock-Based Compensation (SBC)
2. Revenue per Employee
Revenue per employee is an important financial indicator because it is a measure of a company's productivity and efficiency. It shows how much turnover a company generates in relation to the number of employees. To calculate revenue per employee, simply divide the company's total sales by the number of employees:
Revenue per employee = Revenue / Number of employees
What does revenue per employee mean?
This figure is important for a number of reasons:
Productivity: A high revenue per employee indicates that the company is making effective use of its workforce. This can be seen as a sign of strong management and efficient processes.
Comparability: This allows companies in the same industry to be compared to see which companies are more productive and efficient. Companies with higher turnover per employee can be seen as more competitive and better managed.
Cost control: A higher revenue per employee may indicate better control of labour costs. As staff costs often represent a large proportion of total costs, particularly for software and platform companies, it is important that companies use their resources efficiently to increase profitability.
Resource efficiency: Revenue per employee helps us as investors and analysts to assess how well a company uses its resources. Companies that can generate more revenue with fewer employees can be considered more efficient. They may offer better long-term investment opportunities.
It is important to note, however, that revenue per employee varies widely from industry to industry and can vary depending on the type of business model. It is therefore important to consider this ratio in the context of the industry and in conjunction with other financial ratios.
Revenue per employee for Meta and Alphabet
The big tech giants Meta and Alphabet generate $1.5-2 million in revenue per employee. This is twice as much as other social media platforms like Snap or Pinterest. It shows the extraordinary profit potential of Meta and Alphabet compared to the smaller social media companies.
3. The Research Ratio (R&D/Sales)
The research intensity, also known as the R&D rate or R&D ratio, is an indicator that measures the ratio of research and development (R&D) expenditure to a company's turnover.
To calculate a company's R&D intensity, the company's R&D expenditure is divided by its revenue and the result is multiplied by 100 to express it as a percentage:
Research Ratio = (R&D Expenditure / Revenue) × 100
What does the Research ratio mean?
The research rate is important for several reasons:
Innovation potential: A higher research ratio indicates that a company is investing heavily in research and development, which should lead to new technologies or products. This can indicate greater innovation potential and growth opportunities.
Competitiveness: The R&D intensity helps to assess a company's competitiveness in the global market. A higher R&D investment ratio may indicate that a company is more focused on remaining competitive and maintaining or improving its market position.
Cost control: Of course, a higher R&D ratio is not a good thing in and of itself. What matters is what comes out of it in the end. If a company has particularly good control over its development costs (e.g. if development is carried out in low-cost countries), a relatively low R&D ratio can also be the basis for financial success. What matters is the trend over time.
It is important to note that the R&D intensity varies widely across industries and can also depend on the type of business model. Companies in technology industries or industries that rely on innovation, such as pharmaceutical or biotechnology companies, tend to have a higher R&D ratio than companies in less research-intensive industries.
Research ratio using Datadog, Elastic and Dynatrace as examples
In the software industry, I always get suspicious when a company spends less than 20% of its sales on R&D. It raises the question of whether the company can keep up with its competitors, some of whom have much higher R&D ratios.
For example, when comparing the various players in the application performance monitoring (APM) and cloud infrastructure monitoring markets, it is clear that Datadog is investing much more aggressively in the future than its direct competitor Dynatrace. Whether it is wise to spend almost half of your turnover on software development in a difficult economic climate for SaaS is another question. In any case, a company with a particularly high R&D ratio like Datadog could significantly improve its profitability in the short term by reducing the research ratio to a "normal" level around 20-25%.
How you can Easily use Advanced Financial Ratios for Yourself
You may be wondering how you can use these advanced ratios in your stock analysis without having to spend time reading annual reports and calculating these composite figures yourself.
It is no coincidence that these ratios are included in the comprehensive toolbox of StocksGuide, which I help to develop. In the Charts section for each stock, you will find Free Cash Flow per Share, Sales per Employee and the Research Ratio (R&D/Revenue) for nearly 7,000 stocks worldwide, as well as over 40 other fundamental ratios.
All of this data is presented in the form of a chart, so you can see the development of these key figures over time at a glance, and even compare several stocks with ease.
For all Dow Jones and Nasdaq100 stocks, the StocksGuide toolset is available completely free of charge. Please check it out and feel free to use the comment section of this post for your feedback.
Disclaimer: I do not receive any compensation from StocksGuide for this recommendation. However, I am an indirect shareholder of the company behind the new StocksGuide product, and therefore participate in the economic success of this platform.