As you look at company metrics, it is necessary to remember that a company will rarely be perfectly consistent. Company results will vary due to a variety of situations, some of which will be outside of company control. For instance, a general increase in the price of gasoline can affect many companies for the positive or the negative.
These market adjustments are extremely difficult for company managers to adapt to rapidly and may force them to grow too quickly, face unforeseen costs, or see a contraction in their core markets. Over the course of a few months, most companies will start to accommodate the new market situations and be back on track; however, that peak or dip may disrupt the metrics for any given quarter.
Because of these incidental disruptions in business, a Confident Investor will not spend too much time digging into a company’s quarterly releases. Instead, focus on the annual numbers. Quarterly statements are more for the sake of allowing you to understand if there has been some significant change in the company’s core business, as opposed to a short-term disruption.
It is vital to look at the changes from year to year and over time. These changes will indicate if the company takes advantage of market situations and weathers bad times well. You thus need to understand how to analyze growth over time and decide if it is acceptable.
The simplest method of averaging these values is to take the last 5 or 10 years of results and calculate the average. Unfortunately, this can give a slightly distorted picture of the current performance of the company. To understand, let’s look at the sales revenue of a fictional company: Acme Widgets, Inc. ACME has the following sales revenue (all numbers below are in millions of dollars).
% increase from previous year
You could gather the first two columns from a variety of sources. The third column is the revenue increase for that year compared to the immediately preceding year. Most third party sites do not provide this information, so you will need to calculate it.
To calculate the third column, simply take the year’s metric, subtract it from the previous year, and divide that amount by the previous year. In the case of 2001, subtract $200M from $150M, which is $50M. If you divide $50M by $150M, the result is a 33.3% increase. If you are a registered owner of my book, The Confident Investor, you can download a worksheet that will help you with this effort by going to http://www.Confident-Investor.com/analysis-worksheet. You will need to be a registered user to access this page but you can register easily and for free by following the instructions.
A casual look at the revenue of ACME shows that they are growing their revenue, but the growth rate has slowed down fairly rapidly. However, if you do the simple calculation as to what percent increase it would take to grow $150M to $600M in 10 years, you would calculate this to be 13.9% per year if compounded continuously. A 13.9% increase year-over-year is great; but that is not occurring in this instance. ACME has not been close to that number for a few years.
You could average the annual rates by adding them up and dividing by 9. This would result in 12.8%. This is not indicative of what you would think of a company that has grown less than 4% for the past few years.
You could also perform a linear regression analysis of the growth rate. Linear regression is a moderately advanced mathematical method of fitting a straight line to a data set. It is easy to compute the linear regression in today’s modern spreadsheets but very complicated to do on paper or in your head. I don’t suggest that investors use linear regression as there is an easier method.
You do not want to focus on the last two to four years, since another company might have exactly the opposite circumstances. Another company could have had relatively flat increases for many years and then just recently hit a significant expansion of business. While you want to reward the recent increase (as it will likely continue to the immediate future), you also want to take in account that the company was flat in the past.
To accomplish this, you need to weight the averages over the years. The more recent years are more influential than the middle years which, in turn, are more influential than the later years. To solve this problem, I created the Decennary Time Weighted Average (DTWA). To learn about DTWA, please read my book as it is well explained in its pages. You can purchase my book wherever books are sold such as Amazon, Barnes and Noble, and Books A Million. It is available in e-book formats for Nook, Kindle, and iPad.
Stock source from OpenClipart.