Not all companies grow equally.
Some companies can scale their operations seamlessly, growing revenue and profits with the kind of efficiency that fuels long-term business success and can deliver life-changing returns for investors.
But other businesses struggle. As they expand, their costs rise just as quickly as revenue, leaving them with shrinking margins, poor returns on capital, and disappointing stock performance.
The difference lies in a business’s ability to scale. By understanding scalability, you can buy stocks that have the underlying infrastructure, strategy, and business model that can support sustained growth.
This article will show you how to identify scalable businesses so you can better assess whether a stock can grow for the long term.
What is Scalability in a Growth Company?
Scalability refers to a company’s ability to grow revenue without a corresponding rise in costs.
Scalable companies operate in a way that allows them to serve more customers, expand operations, or launch new products and increase profits along the way.
Scalable vs. Non-Scalable Business Models
Scalability is a key determinant of whether a company can sustain its growth over time.
Companies that are not scalable often hit a ceiling where increasing revenue becomes too costly, which ultimately caps their potential.
Scalable business models often leverage automation, technology, or digital infrastructure so that revenue can scale without cost increases.
Non-scalable models, like consulting or custom manufacturing, often rely on human labor and struggle to grow without a significant rise in costs.
Scalable Example: Shopify’s SaaS (Software as a Service) model is highly scalable. Whether it serves 10,000 or 1 million customers, the incremental cost of adding each new user is relatively small, allowing Shopify to grow efficiently.
Scalable Example: McDonald’s franchise model has turned a traditionally non-scalable business into a scalable one. By partnering with franchisees, McDonald’s can focus on opening new locations without shouldering the full burden of growth. This has enabled the company to scale a physical, location-based business globally.
Non-Scalable Example: A high-end custom tailoring business is inherently non-scalable. Each suit requires hours of skilled labor, precise measurements, and one-on-one client consultations. Since the work is highly personalized and dependent on human craftsmanship, the business cannot easily expand without a proportional increase in skilled tailors and time, making growth costly and difficult to scale efficiently.
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Key Scalability Factors
These are some of the common factors behind a company with a scalable business model:
- Low incremental costs
- Technology-driven operations
- Economies of scale
- Strong leadership and vision
- Network effects
- Profit growth outpacing revenue growth
- Stable gross margins
- Free cash flow growth
Qualitative Factors that Drive Scalable Companies
Low Incremental Costs (Scalable Product or Service Design)
A product or service that can be replicated or delivered to additional customers with minimal cost increases is inherently scalable.
Scalable companies have low marginal costs for serving additional customers. Once the infrastructure is in place, adding more users or customers doesn’t require significant new expenses.
Typically, digital products tend to have higher scalability due to their low incremental costs.
Example: Netflix spends heavily upfront on content creation, but once the shows and movies are available on its platform, the cost of serving an additional user is negligible.
Pro Tip: Examine the company’s gross margins. High and stable gross margins often signal a business with low incremental costs and scalable operations.
It’s best to look for businesses with over 50% gross margins, but the businesses that can really kill it have over 80% gross margins.
Technology-Driven Operations
Technology often plays a central role in enabling scalability. Automated systems, algorithms, and digital platforms allow businesses to handle increased demand efficiently.
It can help to look for companies that heavily invest in technology to automate and streamline their processes. These businesses are often better positioned to scale efficiently.
Example: Amazon uses advanced robotics and logistics software to manage its massive warehouse operations. This technological foundation enables Amazon to scale its e-commerce business without a proportional increase in labor costs.
Economies of Scale
As companies grow, they often benefit from economies of scale, which allow them to spread fixed costs over a larger revenue base. This leads to lower costs per unit and improved profitability.
Example: Tesla has invested heavily in scaling its production capacity, which has allowed the company to reduce costs per vehicle as output increases.
Pro Tip: Pay attention to trends in the company’s operating margins. Improving margins over time can indicate that the business is effectively achieving economies of scale.
Strong Leadership and Vision
Scalable companies often have leaders who understand how to build systems and processes that enable growth. Effective leadership ensures that operational challenges are addressed proactively.
Example: Jeff Bezos at Amazon emphasized long-term thinking and invested in scalable infrastructure like logistics and cloud computing, allowing Amazon to scale globally.
Pro Tip: Research the leadership team’s track record. Leaders with experience scaling businesses are more likely to build a sustainable growth engine.
Network Effects
Network effects occur when a product or service becomes more valuable as more people use it. This phenomenon often drives scalability by encouraging organic growth and customer retention.
Example: Facebook leveraged network effects to scale its platform. As more users joined, the value of the platform increased, attracting even more users and advertisers.
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Financial Metrics to Assess Scalability
Profit Growth Outpacing Revenue Growth
A scalable company demonstrates the ability to grow its revenue faster than its expenses, resulting in profits growing faster than revenue. This indicates that the business can handle increasing demand without proportional cost increases, which is critical for long-term profitability.
Example: Shopify consistently grew its revenue while keeping its operating costs under control, showing that it could onboard more merchants without significantly expanding its cost structure.
Pro Tip: Compare the company’s year-over-year revenue growth to its operating expense growth. If revenue growth consistently outpaces expense growth, it’s a strong indicator of scalability.
Stable Gross Margins
High and stable gross margins are a hallmark of scalable businesses. A company with strong gross margins can invest more in growth initiatives without sacrificing profitability.
A company that is consistently improving its gross margins may be optimizing its cost structure to better scale.
Example: Apple’s gross margins have risen over time due to the growing share of its high-margin services segment, which includes the App Store, iCloud, and Apple Music. As more customers enter Apple’s ecosystem, the revenue from services grows with minimal additional costs, boosting overall profitability.
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Free Cash Flow Growth
Free cash flow (FCF) is a key metric for evaluating whether a company’s growth is sustainable. A scalable company generates positive and growing free cash flow as it scales, providing resources for reinvestment and reducing reliance on external funding.
Example: Netflix’s strong free cash flow in recent years has enabled it to fund original content production while expanding its global footprint.
Pro Tip: Evaluate whether the company’s free cash flow is growing alongside its revenue. This indicates that the company can scale efficiently without compromising its financial health.
Frequently Asked Questions (FAQs)
1. What does scalability mean in a company?
Scalability refers to a company’s ability to grow revenue without a proportional increase in costs, allowing it to expand efficiently and improve profitability.
2. What are examples of scalable businesses?
Examples of scalable business models include subscription-based software (e.g., SaaS), digital platforms (e.g., Netflix), and businesses with strong logistics infrastructure (e.g., Amazon).
3. How can you assess if a company is scalable?
You can assess scalability by analyzing financial metrics like gross margins, operating margins, and revenue growth relative to expenses. Qualitative factors like automation, network effects, and leadership also play a role.
4. Why is scalability important for investors?
Scalability is important because it indicates whether a company can sustain growth and profitability as it expands. Scalable companies often generate higher returns over the long term.
5. What are common challenges companies face when scaling?
Common challenges include managing operational inefficiencies, maintaining quality, and dealing with increased competition as the company grows.
TIKR Takeaway
Scalability is important for determining whether a company can sustain growth over time and deliver strong shareholder returns.
By focusing on stocks with traits like low incremental costs, technology-driven operations, digital products, and network effects, investors can identify businesses with the potential to scale effectively.
The TIKR Terminal offers industry-leading financial data on over 100,000 stocks, so if you’re looking to find the best stocks to buy for your portfolio, you’ll want to use TIKR!
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Disclaimer:
Please note that the articles on TIKR are not intended to serve as investment or financial advice from TIKR or our content team, nor are they recommendations to buy or sell any stocks. We create our content based on TIKR Terminal’s investment data and analysts’ estimates. We aim to provide informative and engaging analysis to help empower individuals to make their own investment decisions. Neither TIKR nor our authors hold any positions in the stocks mentioned in this article. Thank you for reading, and happy investing!
