What Are Multibagger Stocks?
The term “multi-bagger stocks” was coined by Peter Lynch in a book he wrote titled “One Up on Wall Street.” A multi-bagger stock delivers returns that are multiples of the investor’s original investment. For instance, if an investor buys shares worth $2,000 and sees their value rise to over $16,000, they have seen an eightfold increase in their investment. This is equivalent to a 700% increase before any fees and taxes are applied.
The appeal of multiplier stocks is clear. Every investor enters the stock market to make money, and the chance to build substantial long-term wealth with a small initial investment is highly attractive. Therefore, the potential for substantial market expansion and a sharp rise in market value can attract investors to various stocks. However, the challenge lies in identifying these stocks before they enter their strongest growth period. It is also important to understand that a stock that rises sharply and generates multiple returns can fall drastically as investors rapidly sell to take profits. Therefore, not every share that rises rapidly will become a long-term winner, and some stocks that appear promising may eventually lose significant share value.
How Multibagger Stocks Work
An equity can become more valuable if the parent company combines sustained business growth with an increase in valuation over time.
Let’s analyze an example of a company that grows its earnings per share from $3 to $6 over several years. That company can also see its price-to-sales ratio increase from 8 to 16. Then the share price could increase to $24-$96. This conclusion assumes valuation and earnings numbers are comparable and that no other factors intervene, such as share dilution or bonus share allotments.
The aforementioned example clearly illustrates the drivers behind multi-billion dollars:
- Earnings growth, in which case the company improves margins, revenues, and operational efficiency to drive annual profits.
- Valuation expansion. It really follows the first factor (earnings growth) because investors tend to want to pay a higher multiple of earnings. Earnings growth indicates the company will deliver stronger future profitability over several quarters and offers a lower-risk investment than other companies.
However, the reverse is also possible. A company can increase earnings even as its share price underperforms if investors are unwilling to pay a higher valuation despite those earnings. This is why the multi-bagger stock must have both factors working in the same direction.
Many AI stocks face the reverse. While their underlying business seems to be doing well because of increased AI demand and higher earnings growth, investors worry that rising capital expenditure could hurt valuations down the road. This concern has taken on more momentum as the Federal Reserve starts raising interest rates and bond yields rise. This scenario shows how certain factors can cause stocks to experience large-scale pullbacks despite rising earnings.
Five Characteristics of Potential Multibagger Stocks
1. A Large Addressable Market with Expansion Capacity
Rising demand offers significant potential benefits and greater opportunities for revenue growth over time. Stocks of companies that operate in sectors with large and addressable markets typically fit the classification of multi-bagger stocks. A multibagger stock operates not just in large addressable markets, but must have the capacity to expand its market share.
Therefore, the question is whether the stock, or the company itself, can increase its market share where demand is already favorable. For instance, the AI cycle has produced many multibagger stocks. However, a multi-bagger stock in the expanding AI sector must prove it can grow its market share to attract investors.
2. Consistent Growth in Revenue and Earnings
A multi-bagger stock exhibits consistent revenue and earnings growth while reducing operating losses and costs. Revenue growth alone can indicate that the company is expanding operations and attracting more customers. Still, that alone isn’t enough to determine whether a company can be a multi-bagger stock. A company could increase revenue and sales but still see operating costs balloon. It may be burning cash faster than it is generating it or may have issued new shares to the point where shareholder value is diluted.
Therefore, a company should show several years of revenue growth, operating margins, earnings per share, and free cash flow, along with a marked reduction in operating costs. These are the things investors look at that could drive demand for the stock and turn it into a multibagger.
3. Strong Management and Corporate Governance
Corporate governance plays a huge role in determining a company’s potential to become a multibillion-dollar stock. Management decisions can affect business growth and whether those gains translate into positive shareholder returns. Corporate governance is what gives multibagger stocks the foundation and pillars for long-term success. It separates the sustainable multibagger stocks from the value-trapping market fads. Strong corporate governance values ensure that any wealth the company makes is properly reinvested to generate higher returns and not dilute shareholder value. Markets typically reward companies with spotless record books and prudent resource management. That is why certain personalities with strong corporate pedigrees joining company boards can rewrite investor confidence stories and turn an otherwise dead stock into a multibagger.
4. A Sustainable Competitive Edge
Having a competitive advantage is the macro engine behind most multibagger stocks. A multibagger stock must have a competitive edge over its peers. Such an edge could come from economies of scale that deliver superior pricing power, or from products that disrupt the market. It could also come from increasing brand awareness/loyalty, securing patents or regulatory approvals, or deploying technology that prevents copycatting.
5. A Valuation with Future Returns Potential
A multi-bagger stock has realistic growth expectations. Any valuation applied to a stock that claims to be a multi-bagger must leave room for future returns. No single valuation ratio fits all businesses. Companies operating in different sectors require different analysis approaches.
The essence of such analysis is to determine if the price being paid by investors for the stock will justify future valuations based on the expectation of growth. It should not be based on assumptions that a so-called high-quality company would automatically bring in a higher return in the future. Therefore, valuation measurements such as price-to-sales, price-to-earnings, EBITDA, enterprise value, and free cash flow must be used where appropriate to determine a company’s growth prospects and any financial service’s historical and future valuations. Only when the company passes the relevant tests and leaves adequate room for future returns, based on the evaluation, can such a stock be considered a multi-bagger.