Imagine having a million dollars to invest in a business. What would you want to know before investing in it? An astute investor would probably ask about the competency of the company's management team. Also, about the competitive landscape and the business’s growth prospects. Why are growth prospects such an important factor?

Just look at the power of growth – or lack thereof – on the share prices of the following two hypothetical companies under a variety of circumstances assuming a long investment horizon. Truly successful investors compound their success by capitalizing on growing businesses and getting that growth for free.

Company A is slowly growing at only 3% annually. Its prospects are limited because demand for its products has matured. Company A’s owners are nevertheless happy to earn a steady and predictable amount of cash from its operations.

Company B, on the other hand, is growing quite nicely, increasing its profits by approximately 12% every year from rising demand for its products. It’s able to steal share from competitors and operates in a market where overall demand is increasing, providing the business with strong tailwinds.

The relationship between earnings and stock prices

While we’d probably all agree that we want to own a company that will be bigger tomorrow, how is growth reflected in stock prices?

There’s a valuation metric called the “earnings multiple,” commonly known as the P/E ratio. This represents the amount an investor is willing to pay for a dollar of a company’s earnings. If a company’s share price is $10 and it earns $1 per share over a year, its P/E ratio is 10.

P/E ratios are highly subjective and influenced in the short term by pervading market conditions and investor perception. Despite stable earnings, a company’s stock price can still fluctuate based on events that may have nothing to do with the business’s underlying operations. In turn, its P/E ratio can be very volatile. There are other ways to assess value, but we’ll stick to this method to illustrate the importance of growth.

Growth in action

The following tables show the value of Company A growing its earnings at 3% with that of Company B at 12% earnings growth in different pricing, or P/E scenarios ranging from 10x to 20x earnings. 

SCENARIO: Buy and sell both companies at the same multiple.

You buy Company A and Company B at a P/E ratio of 10, meaning you pay $10 for every dollar of earnings and equally value both companies despite their growth differences. Assume the multiple doesn’t change and in 10 years you sell both businesses also at 10x earnings.

Multiplying their initial earnings by 10, you get $10 per share for each business. By year 10 at 10x earnings, Company A is worth $13.44 per share ($1.34 x 10). That’s a 34.4% cumulative return ($10 grows to $13.44).

In contrast, Company B is worth $31.06 per share for a cumulative return of 211%. Now that’s a big difference! This example highlights growth’s impact on the value of a business over time. As a Company A investor, the stability you sought unfortunately costs you dearly in the long term.

Multiple expansion or contraction

Buying undervalued businesses can be another way to make a good investment return. Instrumental to this approach is finding value others don’t yet recognize. This can lead to a “multiple expansion” – a willingness on the part of investors to pay more for a dollar of earnings sometime in the future. An example of this is a company valued at a P/E ratio of 10 that subsequently increases to a P/E of 20 without any change to its earnings. If you buy a stake at 10x earnings and sell it at 20x, you double your money even though the business hasn’t grown.

When investors feel confident in the future and have a rosy outlook, businesses often gain popularity and buyers are willing to pay more for them. A change in multiple can dramatically affect a company’s share price, positively or negatively.

The following scenarios illustrate the impact of multiple expansions and contractions on investment returns.

SCENARIO: Multiple expansion

You buy Company A cheaply at a 10x P/E ratio and sell it higher at a 20x P/E ratio.

You’re a smart investor who recognizes value. You buy Company A at 10x earnings when no one else is interested in slow-growing, unexciting businesses and pay $10 per share.

Sentiment changes and other investors start to flock to businesses like Company A. As a result, its share price spikes. Company A is now valued at 20x because investors are willing to pay twice as much for the same dollar of earnings. If you sell at this point, you double your money even before accounting for any growth. Include that 3% annual growth rate for the ensuing 10 years and your $10 investment is now $26.88, a tidy return of 169%. Finding undervalued businesses can help you to achieve superior investment performance like this.

How does the strategy compare to buying and selling fast-growing Company B at 20x earnings without the benefit of a multiple expansion? Well, you pay $20 for Company B and sell it 10 years later for $62.12, a 211% return. Even without the nice bump in P/E ratio, you do better than your investment in Company A. Company A’s multiple expansion was simply no match for Company B’s growth!

Though what’s great in theory doesn’t always translate as well in the real world. In this case, you’d be hard pressed to find a company that can consistently grow 12% a year for a decade. And realizing growth’s compounding benefits takes patience. Not until year 9 does Company B exceed Company A’s 169% return. However, the scenario illustrates the power of growth, which can help to compensate for any lack of skill in correctly identifying underpriced opportunities.

SCENARIO: Multiple contraction

Worried about the world, you seek comfort in Company A’s stability and pay 20x earnings for it. 10 years later, the bad news has disappeared and everyone wants fast-growing businesses. You sell the company for only 10x earnings in what’s called a multiple contraction.

You’ve paid $20 per share for a company that’s worth only $13.44 a decade later. In other words, you’ve lost 33% of your original investment despite the company continuing to grow 3% a year.

Measure this against buying Company B growing 12% annually. Even if you pay 20x earnings and experience a 50% multiple compression, you still make a 55% return ($20 grows to $31.06). Except it’s not as easy as just buying growth. You have to also be able to stomach the multiple crunch for a sustained period. In this example, you lose money for the first six years of your investment – as much as 30% by year 3. You can see how a multiple compression negatively impacts returns even for companies with high growth rates. Also, you quickly learn the importance of entry price. Overpaying for a business is one of the fastest ways to lose money. Luckily for Company B investors, growth helps cushion this fall.

A key to building wealth

These scenarios all show how finding growing businesses at the right price can prove a sound investment strategy. While not easy to execute on, done well this approach can help you to create wealth over the long term.