YoY growth is a very popular metric on Wall Street.
The term YoY means year over year, and it’s the difference in a company’s financials between one year and the next. It’s often used to evaluate growth of revenues, earnings, cash flows and/or book value.
If you’re not 100% of each of those accounting terms, don’t worry. You’ll still understand this blog post and learn something important from it.
Not only that, but using averages instead of YoY growth is something that most of Wall Street doesn’t really think about. Partly because there’s no financial incentive to the professionals in the thick of it (maybe even counterproductive career-wise). Maybe the other part is ignorance.
Anyway, let’s get to it.
First things first. Let’s show the formula for YOY growth, then talk about averages.
YOY = ([Current Year] – [Previous Year]) / [Previous Year]
This estimates the one year growth rate. So if you had a company that earned $100 last year, and then grew earnings to $120 this year, you’d have a company with 20% growth YOY ([120 – 100) / 100] = 0.2 = 20%
Now, here’s why I prefer evaluating growth with averages…
Averages paint a better picture than YoY growth for pretty much every metric used in the stock market.
YoY growth can vary wildly, while averages smooth things out and have a better chance of being more reliable. Especially as you increase the time range.
Let’s use an example.
YOY Growth Variance vs. Long Term CAGR (Example)
Say there was a company out there that had $4 of operating earnings in 1965 and $2500 in 2005. Using a CAGR calculator, that’s a growth rate of 17.46% per year.
Taking it a step further, say that the company grows operating earnings 10% into 2006, turning the amount into $2700 and adjusting the growth rate to 17.22%.
Let’s say that in an alternate universe, the company actually grew to $5000 in 2006. On a YoY basis, the earnings growth would be 100% ($2500 to $5000). But the 41 year CAGR growth rate would only bump to 19.0%.
Like I said at the onset, we have wide variance in YoY growth.
We saw 2 differing situations, one with 10% YoY growth and one at 100%. In spite of that, we saw much less variance over the long term. There was only a difference between 17.22% / year and 19.0%.
Granted, this little difference in percentage points can compound to massive differences over the long term.
But when looking at stocks and trying to evaluate them, it’s important to consider how YoY growth can be greatly skewed to make one stock look much better than the other, when it’s not really the case.
An investor might see a stock with 100% YoY growth and prefer it to one with 10%. But that huge one year growth could mean something other than successful business growth.
For example, a company could win a lawsuit that gets paid out in, say, 2006. A one-year windfall of earnings, but not necessarily indicative of an ability to consistenly earn that level of earnings in the future.
Take the long term hypothesis again.
Long Term Growth vs. YOY (Example #2)
Say there was a stock with a 1.77% CAGR growth from 1965- 2005. Say it had 100% YoY growth into 2006, so now the long term CAGR was 3.44%.
And say you also had the option to buy the business with 17.46% growth from 1965- 2005, the one that only grows 10% YoY into 2006 to adjust the CAGR to 17.22%.
It should be obvious that the 2nd option has the business that is truly growing over the long term consistently (17%+ yearly).
But an investor using YoY growth only wouldn’t have caught that.
You see, when you zoom out of the YoY fluctuations, you literally get a bigger picture on the true long term health of a business. A 10% YoY earnings growth might not sound impressive, but it can signal a very strong business if it’s routinely doing 10-30% YoY numbers per year– which you can only catch if you look over a long enough time period.
Wheras a stock with a 100% or 150% YoY might do great in the stock market for a few months, it can also get hammered if that growth rate isn’t sustained. A wild swing up can also result in an equal and opposite wild swing down.
If the company isn’t showing a great long term track record of growth, then you can infer that either (or even both):
A) Management is terrible at investing the profits of boom years to stay sustainable
B) The YoY growth is more likely an anomaly rather than a growth signal
This is why growth rates should be measured over the long term, and why that’s exactly how I analyze growth personally. I do look at YoY growth numbers when I look at stocks, but the difference is that I don’t depend on them.
Instead I like to zoom out and get the big picture.
These are critical to understanding which stocks truly create the greatest gains for investors over the long term. With each new stock pick I’m considering, I think about the growth picture– especially honing in on the long term track record of the business.
Building a portfolio of these exact kinds of stocks increases the chances of out-sized success with each new pick. Rather than relying on getting lucky, I’m trying to stack the odds in my favor.
This tends to keep me out of stocks with high YoY growth, but not always. The approach isn’t mutually exclusive. But if I had to pick one, I’d pick a long term average over 1 great YoY growth metric every single time.
It really comes down to math.
The math just works itself out over the long term, as you can see from my simple example above.
When Wall Street is so short term focused (as it is), you can give yourself a major advantage by looking instead at the long term.