When Growth Becomes a Trap: How Investors Can Tell Good Growth From Expensive Growth

Fast-growing companies have an obvious appeal for investors. Their stocks seem like an easy winner, as they provide rising revenue and expanded earnings. However, growth itself isn’t enough to guarantee a smart investment.

A company can lose value while growing if the growth requires large amounts of capital and doesn’t produce comparable results. That creates an important distinction between good growth and expensive growth. The former is the growth that increases the value of the company.

For the investors, the challenge is to go beyond financial statements and to truly assess how the company will do in the years to come and what it has to provide to employees, customers, and investors alike. Business growth, profitability, reinvestment, and valuation need to make sense together.

What Is “Good Growth”?

Simply put, good growth is growth that provides more value than the resources needed to produce it. For instance, if a company needs to spend heavily on factories, acquisitions, marketing, and working capital to achieve growth of 20 percent annually, investors may not find it to be worth the effort.

The metric used to measure this distinction is called return on invested capital (ROIC). If the return on capital is greater than its cost of capital, it is generating economic profit and creating value for shareholders. ROIC is therefore the major driver of value creation.

It’s also important to note the connection between growth and reinvestment. Operating-income growth can be described as a product of the reinvestment rate and return on capital. Two companies can have the same level of growth, but still have completely different economies and values.

The First Warning Sign: Growth That Needs Too Much Capital

Growth is never free; it requires investment on the part of the business. Sometimes, the investment can be rather low. For instance, creating a crypto coin that can get access to some of the best decentralized exchanges is relatively inexpensive. However, creating the infrastructure to handle numerous transactions made with that crypto asset is costly, and that’s what the coin needs to grow in value.

Investors should therefore examine capital expenditures, working capital, acquisitions, and research and development alongside revenue growth.

Another metric to pay attention to is cash flow. If a business venture has revenue and accounting earnings that are rising rapidly, but is always short on cash, investors should reconsider. However, it doesn’t always mean they should give up on such a business.

A simple way to ask this question can be “How much additional capital does the company need to generate each additional dollar of revenue or profit?”

The Quality of Growth: Where Are the New Customers Coming From?

The quality of growth is more important than its size. Investors should endeavor to find where the new revenue is coming from, which means where the new customers and clients are coming from. The company can find new customers, or they can get the existing ones to spend more. Both options have their limits and downsides for long-term growth. Experts such as those from CryptoManiaks have written about altcoins that are dealing with this problem in particular. They generate interest from potential users, but can’t scale up and onboard new users.

Growth can be driven simply by price increases, and that’s something that should worry investors. An increase in demand is a favorable option, but it too reaches a limit at some point, since there are very few products and services that can continue to grow at all times.

Customer retention is particularly important for subscription and recurring-revenue businesses. High retention can have a compound effect on the company’s growth. This means that as each new group of customers is added, it costs the company less to maintain the services they provide and to retain that group.

The key question is therefore not simply “How quickly are sales growing?” but “What is causing them to grow?”

When Growth Starts Getting Harder

Investors should also ask themselves what happens when the company they are investing in becomes much larger. A new business can easily find new revenue for growth. It’s usually done by expanding to a similar market or by introducing new services and products which are similar to the initial offer.

However, such opportunities can’t last forever, and businesses often can scale outside of a certain limit. Investors should look for evidence that the company’s addressable market is large enough to support its long-term ambitions. It’s also important to note that reaching new markets often isn’t as profitable as being a company comfortable in a small niche.

This problem is especially difficult for companies that seek investors by going public and having shareholders. They are usually looking for long-term growth that will justify their investments, often for decades to come, and not all companies are suited for it.

The Biggest Trap: Paying Too Much for Good Growth

The most dangerous misconception the investor faces is that a good company is also a good investment. A company can have excellent management, strong competitive advantages, and high ROIC and rapidly growing earnings. But its stocks still don’t have to be a good investment, since the market has already priced in years of exceptional performance.

Investors can use measures such as forward P/E, EV/EBITDA, price-to-sales, and free-cash-flow yield to understand how much the market is paying for a company’s expected performance. None of these metrics is perfect, especially so when it comes to companies working in different industries and with unique business models.

Suppose a stock trades at a very high multiple because investors expect revenue to compound rapidly for many years while margins eventually reach exceptional levels. This means that the growth can slow down earlier than expected or that the margins may be disappointing. In those cases, the stock value will drop even if the company is doing well.

The investors are not buying growth. Instead, they are buying the future cash flow, which is produced by growth at today’s prices.

How to Spot Unrealistic Growth Expectations

One of the ways to spot expensive growth is to work backwards from the company valuation. Investors should ask themselves what it takes for the stock price they’re working with now to make sense. There are several warning signs to take into account.

Growth forecast that’s far above historic performance.
Rapid expansion accompanied by declining returns can indicate that the company is moving into less attractive markets.
Growing revenue while dealing with cash flow lags.
Companies that rely heavily on acquisitions. Buying revenue can make growth look impressive without necessarily improving underlying economics.
Rising capital needs. Expansion becomes less attractive when a company needs a lot of investment for every expansion in revenue.
Aggressive terminal assumptions. If evaluation depends on rapid and sudden growth, investors should be cautious.

Competitive Advantage Determines How Long Growth Can Last

Growth rates don’t exist in isolation. If a company has a competitive edge over its competitors, it can maintain growth or even expand it. There are several such edges that investors should look into. These include: network effects, switching costs, powerful brands, cost advantages, economies of scale, and proprietary technology.

High returns will attract competitors. If a company is facing a very profitable market, other companies will try to get in on it, and it can cause the prices to fall, at least at first. In many cases, a company with 15 percent growth and a competitive edge could be more profitable than one with 30 percent growth, without something separating it from the competitors.

The investors should ask themselves if the company can maintain its place in the market when two or three new competitors emerge.

Conclusion: Investors Should Buy Value-Creating Growth, Not Growth at Any Price

Investors are looking for companies that will grow and expand in the future and continue to provide profits, as long as possible. However, not all growth is made the same, and the market isn’t about finding the company that has the biggest growth rate.

It should be to find businesses where growth produces attractive returns on capital, requires sensible reinvestment, and can be sustained through a durable competitive advantage. Even a great business, bought at an extreme valuation, can be a disappointment for an investor. An investor should be aware of how much growth they are buying and what to do if the company underperforms.

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More Recommended Ebike/Scooters

Check out these other ebikes and scooters I've reviewed:

Urban Arrow Ebike – Last year, I made one of the largest purchases I’ve ever made – I bought a $9,000 electric cargo bike from Urban Arrow. In my Urban Arrow review, I will discuss what it is and why I decided to buy this bike, as well as discuss how impactful a bike like this can be on your journey to financial independence.
Troxus Explorer Step-Thru Ebike – The Troxus Explorer Step-Thru is a fat-tire ebike that I’ve had the pleasure of riding for a while now. It has amazing power, great looks, and awesome range. If you’re looking for a great fat-tire ebike that offers a lot for the price, the Troxus Explorer Step-Thru is definitely one for you to consider. Check out my Troxus Explorer Step-Thru Review.
Hovsco HovBeta Ebike – The HovBeta is a folding ebike with great specs and a lot of interesting features, and importantly, it’s sold at a good price point. I’ve had a blast commuting with it and using it to do deliveries with DoorDash, Uber Eats, and Grubhub. Check out my Hovsco HovBeta Ebike Review.
Vanpowers Manidae Ebike – The Vanpowers Manidae is a fat tire ebike that I’ve been riding as my primary winter commuting bike and have also been using it to do food delivery with apps like DoorDash, Uber Eats, and Grubhub. After clocking in a decent number of miles with this ebike, I wanted to write a post sharing what my experience with the Vanpowers Manidae ebike has been like. Check out my Vanpowers Manidae Review.
Sohamo S3 Step-Thru Folding EBike Review – A Great Value Folding Ebike – The Sohamo S3 Step-Thru Folding Ebike is an entry-level folding ebike that offers a lot of value for the price point. I’ve been riding the Sohamo S3 for a while now, putting the bike through its paces, and I have to say, this bike has exceeded all of my expectations. Check out my Sohamo Review.
KBO Flip Ebike – The KBO Flip is an excellent bike. I’ve had a great time riding it and think it’s a versatile bike that can be used for a lot of purposes and can fit a variety of lifestyles. It’s worked out great for me as a general commuter bike and as a food delivery bike. Check out my KBO Flip Review.
Hiboy P7 Commuter Ebike – The Hiboy P7 is an excellent electric commuter bike that’s offered at an affordable price point. The range and speed of this bike are both very good, so you won’t have any trouble getting anywhere you need to go with it. As a food delivery vehicle, this is also good – with how much range it offers, you’ll be able to work all day on a single charge. Check out my Hiboy P7 Commuter Electric Bike Review.
Himiway Escape Ebike – The Himiway Escape is an interesting bike for anyone looking for a moped-style ebike. If you’re a gig economy worker, the Himiway Escape is particularly interesting and it’s possible to think of it as an investment, especially if you can opt to do deliveries with the Himiway versus using a car. It’s not cheap, but you can definitely make your money back when you compare the mileage you’ll put on your car versus using an ebike. Check out my Himiway Escape Bike Review.
Espin Sport Ebike – The Espin Sport is a good ebike for someone who is looking for an ebike that feels and rides more like a regular bike. There are many ebikes that are really only bikes in name. In reality, they’re basically electric mopeds. The Espin Sport, by contrast, is a bike you could probably ride without the battery and you’d feel like you’re just riding a regular bike. Check out my Espin Sport Review.
Varla Eagle One Scooter – The Varla Eagle One is an excellent scooter that can make sense for a lot of people. It can work as a primary mode of transportation. You can use it to work on gig economy apps like DoorDash, Uber Eats, and Grubhub. And it can also be a recreational vehicle if you’d prefer to use it for that. Check out my Varla Eagle One Review.
Varla Falcon Scooter – The Varla Falcon is an excellent scooter that offers a good amount of power at a lower price point compared to more powerful scooters. It’s not exactly an entry-level scooter, nor is it a high-powered scooter. I think it fits somewhere in-between those two categories – an intermediate scooter if I had to give it a category. Check out my Varla Falcon Review.
Hiboy S2 Scooter – The Hiboy S2 is an excellent entry-level commuter scooter that's perfect for someone looking to save some money in transportation costs and improve their commute. Check out my Hiboy S2 Review.
Hiboy S2R Scooter – The Hiboy S2R is one of the more interesting electric scooters I’ve been able to test out. It’s not a high-powered scooter, but for an everyday transport option, it’s very useful, especially given some of the unique features that it has. Indeed, for the price, the Hiboy S2R might be the best value scooter I’ve used. Check out my Hiboy S2R Review.
Fucare H3 Scooter – The Fucare H3 is a fun scooter and I’ve enjoyed testing it out. For a daily commuter or quick trips or errands, the Fucare H3 is probably the scooter I’ll use. It’s portable and easy to maneuver, so it’s just easier to take on the road when I need it. Check out my Fucare H3 Scooter Review.

More Recommended Investing App Bonuses

For additional investing app bonuses, be sure to check out the ones below:

M1 Finance ($75) – This is a great robo-advisor that has no fees and allows you to create a customized portfolio based on your risk tolerance. You also get $75 for opening an account. Check out my M1 Finance Referral Bonus – Step-By-Step Guide.
SoFi Invest ($25) – SoFi Invest is an easy brokerage account bonus that you can earn with just a few minutes of work. Use my SoFi Invest referral link, fund your SoFi Invest brokerage account with just $10 and you’ll get $25 of free stock. I also have a step-by-step guide for the SoFi Invest referral bonus.
Robinhood (1 free stock) – Robinhood gives you a free stock valued between $2.50-$225 if you open an account using my referral link.
Public (1 free stock) - Public gives you a free stock valued between $3-$70 if you open an account using my referral link.

More Recommended Bank Account Bonuses

If you’re looking for more easy bank bonuses, check out the below options. These bonuses are all easy to earn and have no fees or minimum balance requirements to worry about.

Ally Bank ($100) – Of all the banks out there, Ally is, without a doubt, my favorite. At the moment, Ally is offering $100 to customers who open an eligible Ally account and meet the requirements. Here are the step-by-step directions to earn your Ally Bank referral bonus.
Chime ($100) - Chime is a free bank account that offers a referral bonus if you use a referral link and complete a direct deposit of $200 or more. In practice, any ACH transfer into this account triggers the bonus. This bonus is easy to earn and posts instantly, so you’ll know if you met the requirements as soon as you move money into the account. I wrote a step-by-step guide on how to earn your Chime referral bonus that I recommend you check out.
US Bank Business ($400/$1200) – This is a fairly easy bank bonus to earn, since there are no direct deposit requirements. In addition, you can open the Silver Business Checking account, which comes with no monthly fees. Check out how to earn this big bonus here.
Current ($50) – Current is a free fintech bank that’s offering new users a $50 referral bonus after signing up for an account using a referral link. Current is an easy bonus to earn and also gives you access to three savings accounts that pay you 4% interest on up to $2,000. That means you can put away up to $6,000 earning 4% interest. That’s very good and makes Current an account I recommend to everyone. Check out my step-by-step guide on how to earn your Current Bank bonus.
Novo Bank ($40) - Novo bank is a free business checking account that’s currently offering a $40 bonus if you open a Novo business checking account using a referral link. In addition to being a good bank bonus, Novo is also a good business checking account. It has no monthly fees or minimum balance requirements and operates a good app and website. Indeed, it’s the business checking account I currently use for this blog. Check out my post on how to easily open a Novo account.
Varo ($25) – Varo is a free fintech banking app similar to Chime or Current. It’s currently offering a $25 bonus to new users that open a new Varo account with a referral link. The bonus for this bank is very easy to meet, all you need to do is spend $20 within 30 days of opening your Varo account. Check out my step-by-step guide to learn how to earn this bonus.

Kevin is an attorney and the blogger behind Financial Panther, a blog about personal finance, travel hacking, and side hustling using the gig economy. He paid off $87,000 worth of student loans in just 2.5 years by choosing not to live like a big shot lawyer.

Kevin is passionate about earning money using the gig economy and you can see all the ways he makes extra income every month in his side hustle reports.

Kevin is also big on using the latest fintech apps to improve his finances. Some of Kevin's favorite fintech apps include:

SoFi Money. A really good checking account with absolutely no fees. You'll get a $25 referral bonus if you open a SoFi Money account with a referral link, and an additional $300 if you complete a direct deposit.
5% Savings Accounts. I'm currently getting 5.24% interest on my savings through a company called Raisin. Opening a Raisin account takes minutes to complete, it's free, and all of your funds are FDIC-insured. I explain how it works, why I'm now using it to store my emergency fund and any other cash savings I have, and why I recommend everyone check it out in this review.
US Bank Business. US Bank is currently offering new business customers a $400/$1200 signup bonus after opening a new account and meeting certain requirements.
M1 Finance. This is a great robo-advisor that has no fees and allows you to create a customized portfolio based on your risk tolerance. You also get $75 for opening an account.
Empower. One of best free apps you can use to monitor your portfolio and track your net worth. This is one of the apps I use to track my financial accounts.

Feel free to send Kevin a message here.