What it means
Every business hopes to grow, but a growth firm is one where expansion is the central part of the story. Revenue may be rising at 20% or 30% a year, and management is spending heavily on hiring, product development and entering new markets.
Profit may be small, or even negative, because so much is put back into the business. Because the cash is reinvested, growth firms tend to pay little or no dividend.
Shareholders expect to be rewarded when the share price rises as the company becomes larger and more profitable. This makes the shares more volatile, since the price depends heavily on expectations about the future.
Valuation is a key topic. Growth firms usually trade on high multiples, such as a high price-to-earnings or price-to-sales ratio, because investors are paying today for profits that are expected later.
If growth slows or disappoints, the share price can fall sharply. A finance team inside a growth firm faces particular challenges.
Cash needs often rise faster than profits, so the business may require new funding through equity or debt. Managers must balance the push for growth against the need to keep unit economics healthy, meaning that each sale should make money once all direct costs are counted.
The nuance is that growth is not automatically good. A firm that grows by selling at a loss or by taking on too much debt may be destroying value.
Strong growth firms show that each extra dollar invested earns a return above the cost of that money. Life stage also matters.
Many growth firms eventually mature, at which point growth slows, margins settle and dividends may begin. Investors who bought on the growth story must then decide whether the shares still deserve a premium.
In practice
Real-world examples.
Example
A cloud software company doubles its customer base in a year and spends most of its income on engineers and sales staff. It reports a small loss but strong revenue growth, and investors accept this because the market is large. The share price rises as long as growth stays on track, and the board watches customer churn closely because it is the first sign of trouble.
Example
A direct-to-consumer clothing brand opens new warehouses and expands into three new countries. Sales grow 40% a year, but the cash it needs for stock rises even faster. The chief financial officer raises new equity to avoid running short of cash and builds a thirteen-week cash forecast to keep a close eye on stock purchases.
Example
A regional restaurant group opens twelve new sites in a single year using profits and bank loans. The owner keeps dividends at zero so that cash goes to new openings. Lenders watch the debt levels carefully, and the covenants require a minimum level of cash cover each quarter.
Formula
Calculation
Revenue growth rate = (current year revenue - prior year revenue) / prior year revenue
Suppose a software company had revenue of $5,000,000 last year and $6,500,000 this year. The increase is 6,500,000 - 5,000,000 = $1,500,000. The growth rate is 1,500,000 / 5,000,000 = 0.30, which is 30%.
If the average company in its industry grew 6%, this firm is expanding five times faster than the average, since 30% / 6% = 5.Case study
Seen in the real world.
Skyline Robotics is an illustrative, fictional manufacturer of warehouse robots. Its revenue grew 35% a year for four years, and its shares traded at a high price compared with its earnings.
When a competitor launched a cheaper product, Skyline's growth slowed to 15% and the share price dropped by more than a third, even though the company stayed profitable. The finance director explained to the board that the valuation had been built on the expectation of very rapid growth.
The board responded by focusing on margins and customer retention rather than growth at any price. In this fictional story, the company's valuation stabilised once investors saw steady cash generation, and the shares became less volatile than they had been during the high-growth years.
Watch out
Common mistakes.
- Assuming a fast-growing company is automatically a good investment, when the share price may already reflect high expectations.
- Ignoring cash needs, since a growth firm can be profitable on paper yet run out of cash.
- Equating growth firm with start-up, when large established companies can also be growth firms.
Questions
People also ask.
How is a growth firm different from a value firm?
A growth firm is priced on expected expansion, while a value firm is typically cheap relative to its current earnings or assets.
Do growth firms pay dividends?
Usually little or none, because they reinvest profit to fund expansion.
What are the main risks?
Slowing growth, rising competition, high valuations and the need for further funding.
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