So which Stock Type do you wish to add to your portfolio?

To highlight fundamental differences between companies, examine each company's historical record, growth rates, cash flows and other financial data.

Based on these fundamental differences, assign it to one of eight groups.  These stock types are:

1. Speculative Growth
2. Aggressive Growth
3. Classic Growth
4. Slow Growth
5. High Yield
6. Cyclicals
7. Hard Assets
8. Distressed.

These stock types address the question:   What kind of company is this?









Here is a quick overview of these very different companies.


Speculative Growth:  Yahoo YHOO.  The premier Internet portal has become one of the giants of the online world in 1999, with an audience in the tens of millions.  It has become consistently profitable, unlike most of its online brethren, but its track record is still so short that it is definitely risky.


Aggressive Growth:  Starbucks SBUX.   The coffee chain has grown like gangbusters while also showing a healthy profit, the two most important characteristics of an aggressive growth stock.


Classic Growth:  McDonalds MCD.  the fast-food giant is a stereotypical classic growth stock:  A well-known name with an established track record.  It's growing steadily, but not as fast as speculative growth or aggressive growth companies. 


Slow Growth:  Procter & Gamble PG.  The consumer-products giant is a good example of this type; its growth is slower than that of even classic-growth companies, but it makes up for this lack of growth with high profitability.


High Yield:  Philip Morris MO.  The food and tobacco giant's stock was hammered in 1999, but the company still gives back much of its enormous cash flow to shareholders in the form of a hefty dividend.  


Cyclicals:  United Technologies UTX.  This industrial conglomerate is a great example of a cyclical stock.  Its business - aerospace equipment, air conditioners, and elevators - are highly sensitive to the performance of the general economy.


Hard Assets:  Barrick Gold ABX.  This company is one of the most consistently profitable gold-mining stocks, but it also illustrates many of the charcteristics unique to companies that sell hard assets such as minerals or oil.


Distressed:  Silicon Graphics SGI.  This maker of computer workstations and server systems was once a hot technology stock, but it has suffered through a lot of problems since the mid-1990s and has seen its stock price tank.

Objective of Fundamental Analysis: To determine a company's intrinsic value or its growth prospects.

Fundamental analysis is forward looking even though the data used is by and large historical.  


The objective of fundamental analysis is to determine:
- a company's intrinsic value, or
- its growth prospects.  


This intrinsic value can be compared to the current value of the company as measured by the share price.  If the shares are trading at less than the intrinsic value then the shares may be seen as good value.


Many people use fundamental analysis to select a company to invest in, and technical analysis to help make their buy and sell decisions.


The analysis of an individual company has two components:

-  The 'story' - what the company does, what its outlook is
-  The 'numbers' - the financials of the company, balance sheet and income statement and ratio analysis.

Always remember that behind all the numbers is a real business run by real people producing real goods and services, this is the part we call "the story".

It is unlikely that you will need to do the number crunching for every company, your time will be more profitably spent developing the company story.  Balance sheets and ratio analysis, both historical and forecast, can be obtained from either a full service or discount stockbroker.


Before trying to leap into the calculations behind fundamental analysis there aresome basic questions that are worth considering as a starting point:

1. Where is the growth in the company coming from?
2. Is the growth being achieved organically or through acquisition?
3. Is turnover keeping pace with the sector and with competitors?
4. What about the profit margin - is it growing?  Is it too high compared to competitors?  If it is too high then new competitors could enter on price reducing margins.  Low earnings could suggest control of the cost base has been lost or factors outside the company's control are squeezing margins.
5. To what extent do profits reflect one-off events?
6. Will profits be sustainable over the long term?

Companies are multidimensional.  For example, debt funding may have increased - this may be a positive move if the funds produce new productive assets.

Read more:

The objective of fundamental analysis is to determine a company's intrinsic value or its growth prospects.

Buy Low - Sell High, Buy High - Sell Higher

Many investors prefer to pay low for a stock and hope that its price will eventually rise. However, they fail to realize that sometimes it is better to pay a higher price for a stock that has the potentials for a future growth. The money you will save from purchasing a down stock may not justify your investment if the stock continues to languish.

For example, let's assume that stock X has a P/E (price to earnings ratio) equal to 25, whereas stock Y has a P/E equal to 8. If you are ignorant enough and decide to make your investment decision based only on this metric, then stock X will seem as being overpriced.

Let us make another assumption, namely that stock X has experienced this overpricing for several periods of times. On the other hand, stock Y has consistently been under the fair price of the market.

What is more, stock X is experiencing a trading activity that is near the 52-week high, whereas stock Y has experienced a 20% down in its trailing 180-day average.

Typically, investors fail to recognize that the maxim stating that what goes down must come up and the vice versa, doesn't always hold truth. There are many exceptions back in the history.

If you follow this maxim, you will probably conclude that stock X is about to decrease. On the other hand, again under the maxim stated above, an investor may conclude that stock Y is about to make its big jump since its price is low and the stock market will recognize its strengths. Both assumptions may turn out to be completely wrong.

Buy High, Sell Higher

This strategy is highly recommended if you expect that the stock will continue to grow in the future. Thus, you should not be scared off by the high price. A stock that provides a steady percentage of growth is worth paying its higher price today, because if it continues to grow at this rate, its price will be even higher tomorrow.

You should make a careful research before following the Wall Street pack. You may probably regret that you haven't purchased the stock several months ago before its price has not jumped to the sky. However, if you make a careful research and verify that the stock possesses good potentials for future growth, then you should not be discouraged from investing in it.

Keep in mind that the stock's price will rise and fall in the short term, but over the long term a growth stock will move upwards.

Buy Low, Sell High

Many investors prefer to search for bargains, which they can later sell at a higher price. However, if you decide to apply this strategy you should be well aware that the price of the stock may not rise again.

Value investors tend to look for stocks that are overlooked and undervalued by the stock market. However, price is only one of the factors that are part of their selection process. The key consideration made is whether the stock provides steady potential for future growth.

Final Piece of Advice

Avoid making investment decisions based only on the price of the stock because a stock that is down is not obligatory to go up. Additionally, a stock that is up may come down and may not. Look at the other metrics in order to make a more educated and successful decision.

http://www.stock-market-investors.com/stock-market-advices-and-tips/buy-low-sell-high-buy-high-sell-higher.html

It’s also important to see some sort of upward trend in revenues and earnings growth.

It’s also important to see some sort of upward trend in revenues and earnings growth.

Value Line Investment Survey is found in most libraries and does a nice job showing long-term company trends. No one likes a company that constantly does worse than the year before, no matter what the value is! Every company needs some sort of “curb appeal” for you to profit from your investment. At some point, you need to sell in order to make money from your investment.

Upward trends help on the resale side of your investment.

Many investors find it hard to distinguish between “cheap” stocks and value stocks. Most times, stocks are low because they deserve to be low. There is nothing wrong with buying a “cheap” stock as long as you know and understand the risks. There are many stocks out there that have large annual losses, high debt levels and no equity. That does not necessarily mean you can’t make money on them, but you should call it gambling rather than investing.


http://myinvestingnotes.blogspot.com/2010/07/characteristics-of-value-stocks_23.html

Don't Be Misled By the P/E Ratio. It's actually growth that determines value.

By Nathan Slaughter Thursday, March 25, 2010

You might know the name Bill Miller. Aside from Warren Buffett, he could be the closest thing the investment world has to a rock star.

Every year, millions of investors set out with one goal in mind: to outperform the S&P 500. Miller's Legg Mason Value Trust did that for an impressive 15 years in a row.

That streak was finally broken in 2006, but his reputation was firmly cemented at that point. From his fund's inception in April 1982 until 2006, Miller steered his fund to annualized gains of +16%. That was good enough to turn a $10,000 investment into $395,000 -- about $156,000 more than a broad index fund would have returned.

After a long overdue slump, Miller's fund is back on top of the charts again. In fact, his fund's +47% gain during 2009 was 1,200 basis points ahead of the S&P 500.

Here's what you might not know. Miller achieved stardom and ran circles around other value fund managers by taking large stakes in companies like eBay (Nasdaq: EBAY), Google (Nasdaq: GOOG), and Amazon.com (Nasdaq: AMZN) -- highfliers that value purists wouldn't touch because of their high P/E ratios.

The message is clear: If P/E ratios are your only value barometer, then get ready to let some profits slip through your fingers. In fact, Investor's Business Daily has found that some of the market's biggest winners were trading at prices above 30 times earnings before they made their move.

All too often, novice investors buy into preconceived notions of what's cheap and what's expensive. A stock with a P/E below 10 may be a better deal than another trading at a P/E above 20. But then again it might not. These figures might get you in the ballpark -- but biting hook, line and sinker can cost you big.

Putting aside the fact that earnings can be inflated by asset sales, deflated by one-time charges, and distorted in other ways, let's remember that today is just a brief snapshot in time.

The point is, when you become a part owner in a company, you have a claim not just on today's earnings, but all future profits as well. The faster the company is growing, the more that future cash flow stream is worth to shareholders.

That's why Warren Buffett likes to say that "growth and value are joined at the hip."

You can't encapsulate the inherent value of a business in a P/E ratio. Take Amazon, for example, which has traded at 66 times earnings on average during the past five years. On occasion, the stock has garnered multiples above 80. Many looked at that figure and immediately dismissed the company as exorbitantly overpriced. And for most companies that would be true.

But as it turns out, the shares were actually cheap relative to what the e-commerce giant would soon become. In fact, the "expensive" $35 price tag from March 2005 is only about 12 times what the company earns per share now -- and guys like Bill Miller that spotted the firm's potential have since enjoyed +230% gains.

Digging into the annual report archives, I see where CEO Jeff Bezos applauded Amazon's sales of $148 million in 1997. Today, the firm rakes in that amount every 2.2 days. Clearly, that type of hyper-growth deserves a premium price.

And that's exactly why price-conscious value investors shouldn't automatically fear growth stocks -- growth is simply a component of value.

Let me show you an example. The table below depicts the impact of future cash flow growth assumptions on Company XYZ which trades today at $10. For the sake of consistency, we will keep all other variables constant.

If free cash flow climb at a modest +6% annual pace during the next five years, then your $10 investment in Company XYZ would be worth about $13.30 per share or a +33.0% return. If cash flow grows even faster, its projected value quickly ramps up to returns of +46.9%, +101.1% or even +148.8%.

We've been taught to believe there's an invisible velvet rope separating value stocks from growth stocks. But as you can see with Company XYZ, it's actually growth that determines value. So don't be blinded to the possibility that the market's most promising growth stocks can sometimes be the cheapest.

Many analysts choose to use the Price/Earnings to Growth (PEG) ratio in addition to the P/E ratio. PEG is a simple calculation -- (P/E) / (Annual Earnings Growth Rate).

The PEG ratio is used to evaluate a stock's valuation while taking into account earnings growth. A rule of thumb is that a PEG of 1.0 indicates fair value, less than 1.0 indicates the stock is undervalued, and more than 1.0 indicates it's overvalued. Here's how it works:

If Stock ABC is trading with a P/E ratio of 25, a value investor might deem it "expensive." But if its earnings growth rate is projected to be 30%, its PEG ratio would be 25 / 30 PEG.83. The PEG ratio says that Stock ABC is undervalued relative to its growth potential.

It is important to realize that relying on one metric alone will almost never give you an accurate measure of value. Being able to use and interpret a number of measures will give you a better idea of the whole picture when evaluating a stock's performance and potential.


http://www.investinganswers.com/education/dont-be-misled-pe-ratio-1115

High Dividend Payout Ratio = High Earnings Growth Rate (??)

I have always been under the impression that a dividend payout ratio must not be too high because it can limit the ability of the company to grow.  I look for a dividend payout ratios that are at least below 60%, preferably even lower.  I have selected this target because I have believed that the lower payout ratio will provide the company with a sizable chunk of earnings to grow the business and with a lower than 60% dividend payout ratio a company can continue to grow its dividend even during time of economic slowdowns or reduced earnings.

It appears that this theory and fundamental analysis principle has been refuted in a study by Robert D. Arnott and Clifford S. Asness (pdf document). Their theory is that higher dividend payouts actually have lead to higher earnings growth. And with higher earnings growth, share prices tend to go up over time which is better for all of us investors. Let’s have a look at their research and findings.

But First a Definition of the Payout Ratio


The payout ratio is the percentage of a company’s earnings that are paid out as dividends. In a nutshell, the payout ratio provides an idea of how well earnings support the dividend payments. More mature companies tend to have a higher payout ratio.

The crux of the Arnott and Asness research really boils down to one chart. Have a look and it is clear that there is a trend happening here.



As you can see, for a high number of companies, the higher the payout ratio is the better earnings growth the companies experienced. Here are some comments from the authors:

• In general, when starting from very low payout ratios, the equity market has delivered dismal real earnings growth over the next decade; growth has actually fallen 0.4 percent a year on average–ranging from a worst case of truly terrible –3.4 percent compounded annual real earnings for the next 10 years to a best case of only 3.2 percent real growth a year over the next decade. 
• From a starting point of very high payout ratios, the opposite has occurred: strong average real growth (4.2 percent), a worst case of positive 0.6 percent, and a maximum that is a spectacular 11.0 percent real growth a year for 10 years.

So what do we, the average investors do with this data?

My view is that I am going to continue to use my 60% payout ratio benchmark, but will not scoff at a higher dividend payout ratio as quickly. I still believe that it is the average historical payout ratio that an investor must be concerned with – any recent jumps in the payout ratio need to be examined to determine why the change occurred.

http://www.thedividendguyblog.com/high-dividend-payout-ratio-high-earnings-growth-rate/

But, do read the article below which contradicts the above findings.

----

High Yields and Low Payout Ratios

The above post has covered high dividend stocks and the fact that they have been better market performers than low yield stocks. However, it has not been simply buying all the high dividend stocks that has been the most powerful. A study conducted by Credit Suisse Quantitative Equity Research looked at high yields and payout ratios. Their study found that it is high yields coupled with low payout ratios that have provided the best gains over lower yield investing. Although the study used a shorter time frame (1980 – 2006) than many of the other studies we have looked at, the data is pretty clear in its messaging. Take a look at the chart below:



It is interesting to see that the stocks that had a high payout ratio as a whole produced worse gains than the S&P 500, but the stocks that either paid no dividends, had a low yield, or had a high yield did better than the S&P 500. That payout ratio is certainly more important than I thought it was based on this study. A high payout ratio can certain indicate trouble in a company and must be watched closely.

http://www.thedividendguyblog.com/day-5-the-dividend-key-high-yields-and-low-payout-ratios/

Share Price: The Key Factors

http://zetafund.com/page2.htm

Total Stock Returns = Fundamental Return + Speculative Return

Over long periods of time, if you take the entire stock market, you would expect the speculative return to be very negligible. This makes a lot of sense, right? In the end, you’ve got to show me the money! And history agrees. Over the last 100 years, the total annualized return for the total U.S. market was 9.6%, and all but 0.1% of that was explained by earning growth and dividends. (See graph below.)





Fundamental Return = Earnings Growth + Dividend Yield

Speculative Return = P/E Ratio Changes

Total Return = Fundamental Return + Speculative Return

What are we buying when we buy a share of a company? Essentially, we are buying a stream of future money. That money is returned to us the form of earnings growth (which increases the share price) and dividends (which goes straight to us as cash).


http://www.mymoneyblog.com/will-future-long-term-stock-returns-be-less-than-8.html

The Little Book of Common Sense Investing by Vanguard founder Jack Bogle

Importance of Earnings Growth

U.S. economy: From Recovery to Sustainable Growth

July 15, 2010, 10:21PM EST

Analysts Pare Revenue Growth Expectations

Investors may not be able to count on robust rates of sales growth to boost earnings in coming quarters

By David Bogoslaw

Equity analysts and investment strategists have been closely watching corporate revenue trends since last summer to see what's driving any improvement in earnings. But investors may not be able to count on improving sales growth as a way to pump up profits: Analysts are dialing back expectations for revenue growth for some of the world's biggest companies.

In a July 13 market commentary, Nicholas Colas, chief market strategist at BNY ConvergEx Group, an investment technology provider, published data showing that analysts' consensus revenue estimates for the 30 stocks in the Dow Jones industrial average for the second, third, and fourth quarters of 2010 have been declining since April or May. Forecasts were lower in July than in April or May for 21 companies of the Dow 30 for the second quarter, for 22 for the third quarter, and for 19 for the fourth quarter, the report said.

The trend toward lower revenue expectations is present in the broader market. In the three months leading up to July 15, 48.7 percent of companies in the Standard & Poor's 500-stock index with available data had their revenue estimates cut, vs. 39.3 percent in the comparable period leading up to Apr. 30 and 37.1 percent in the three months leading up to Jan. 29, according to Bloomberg data. The start of fourth-quarter earnings releases is typically mid-January, while first-quarter earnings are released beginning in mid-April.

Colas has been tracking analysts' projections for revenue growth for the past year and says that until April those numbers had continued to climb "every single month, month in and month out," reflecting analysts' expectations for further improvement in quarterly earnings. But the trend over the past two months has flattened and is now declining. That's coincided with an 8.0 percent pullback in the S&P 500 index between Apr. 15 and July 15, and Colas believes there's a link between the two.

"For the first time since the [March 2009] market lows, analysts now realize they have overshot on revenue expectations and now are starting to pull them back in," he says. "Earnings expectations have not declined, so analysts have cut revenue expectations but have given companies more credit for [continuing] cost cuts."

IMPACT ON STOCKS
Doubts about the strength of revenue growth over the past year could pose problems for continuing advances in stock prices. "What do you pay for earnings if you're not sure what the structural growth rates are? That's a big, big question," says Colas. "One proxy for structural growth is revenue growth."

While two-thirds of the 30 Dow components seems like a large proportion, the index contains a lot of blue chip companies whose sales are highly correlated to U.S. gross domestic product, says Jeffrey Kleintop, chief market strategist at LPL Financial in Boston. As GDP projections for 2010 have moderated, it makes sense that consensus estimates for revenue growth would follow suit, he says. On July 14, the Federal Reserve lowered its economic growth estimate for 2010 to 3 percent to 3.5 percent from a forecast of 3.2 percent to 3.7 percent given in April.

It's fair to wonder whether the increasing percentage of downward revisions reflects the extent to which analysts may have been blindsided by the European sovereign debt crisis and the slowdown in China, not to mention the soft patch that the U.S. economy has hit. It may be that analysts' optimism about economic growth at the start of a new year tends to fade as the year wears on, which is borne out by patterns in 2009 and so far in 2010, says Peter Nielsen, manager of the Sextant Core Fund (SCORX) at privately held Saturna Capital in Bellingham, Wash.

Another thing to keep in mind: "There's a lot of noise" in the year-over-year comparisons for revenue due to the absence of growth drivers such as cash for clunkers and other government stimulus programs that boosted companies' sales in 2009, says Nielsen. That may be one reason for the conservative revenue numbers coming from many brokerage analysts, he adds. Nielsen thinks year-over-year comparisons will become more difficult as the year progresses and expects "very modest" revenue gains in the third quarter.

It also makes sense that analysts would be paring their revenue estimates around the one-year anniversary of what most economists agree was the bottom of the economic cycle, says Craig Peckham, equity product strategist at Jefferies & Co. (JEF). It's logical to conclude that revenue growth will disappoint investors as year-over-year earnings comparisons become more challenging later this year, he says.

REASSURING EARNINGS REPORTS
The central issue is that investors are unwilling to pay as much for earnings growth driven more by cost-cutting than by improvement in sales. "What you pay for an earnings multiple for cost-cutting is less than what you pay for revenue growth because cost-cutting has to stop somewhere" while revenue growth has "a longer runway," says Colas.

Encouraging second-quarter earnings reports may be enough to stanch the flow of negative revisions and confirm the view that analysts have reduced estimates too far on concerns about Europe, as well as doubts about consumer spending in the U.S., says Jefferies' Peckham. The performance of some equity market bellwethers seems to suggest that analysts may be relying too heavily on pessimistic macroeconomic data that have come out in the last two months, he adds.

Alcoa (AA) reported earnings of 13 cents per share on July 12, beating the Street's forecast by a penny, on a 22.2 percent rise in revenue from a year earlier. On July 13, Intel (INTC) posted a profit of 51 cents per share, up from 18 cents a year earlier and beating analysts' expectations by 8 cents. The microchip manufacturer's revenue rose $2.7 billion, or 33 percent, from a year earlier, exceeding the consensus forecast by $549.9 million, or 5.5 percent. Intel projected third-quarter revenue of $11.2 billion to $12 billion, the lower range of which was ahead of the consensus estimate by $289.35 million, or 2.7 percent, a day prior to the earnings release.

In making the transition from recovery to sustainable growth, the U.S. economy faces some key obstacles such as Europe's fiscal problems and the weak domestic labor market, according to a midyear outlook report by LPL Financial published on July 12. While U.S. banks are fairly insulated from European debt woes, LPL said that U.S. exports and business spending are vulnerable to a pullback in global economic growth that could result from another freeze of liquidity and trade, as well as to the euro zone slipping back into recession due to cuts in government spending, tax hikes, and higher borrowing costs.

TYPICAL RECOVERY SLOWDOWN
Kleintop thinks analysts were caught by surprise by negative macroeconomic data on home sales, retail sales, and job creation. That's not unusual since analysts tend to focus more on microeconomic data related to companies they cover than what's happening in the broader economy. But the fact that the economy has hit a soft patch a year into the recovery is typical of each of the past several recoveries, he says. Each time, the soft period didn't halt the expansion, but it did slow the pace of economic growth and result in a flat stock market for about a year, he says.

Another source of confusion for the market is the divergence between robust manufacturing data and a resurgence of caution among consumers. While the manufacturing strength is encouraging, that's a small part of the economy relative to consumer spending, which accounts for roughly 70 percent of GDP. The fact that the dominant sector is so sluggish "makes this recovery somewhat fragile and susceptible to a downside shock," says David Joy, chief market strategist at RiverSource Investments. He thinks consumer spending will probably remain soft, making a 3.0 percent gain in GDP the best the U.S. can muster for the foreseeable future.

It's worth noting how questions about economic growth have been translating into stock performance, he says. "We're noticing valuations within the market are very compressed. Investors are saying large caps are no better than small caps, that high-quality stocks are no better than low-quality ones," he says. "That tells us where you want to be is in large-cap, high-quality stocks," which have more reliable earnings growth and tend to pay dividends and aren't selling at a premium to lesser-quality names as they usually would.

But by focusing on revenue growth, investors may be overly conservative in their outlook for earnings growth. U.S. companies slashed costs dramatically at the bottom of the cycle, paving the way for outsized earnings growth once revenues recover even modestly, says Peckham. "Companies have been able to create cost structures with a ton of operating leverage. If you've got a model with good operating leverage, your earnings should go up a lot faster than your revenues," he says.

CORPORATE OUTLOOK WATCH
Second-quarter earnings, which have just begun to be reported, are likely to ease market jitters as key economic questions such as the impact of Europe's debt and growth problems are put in perspective, says Kleintop. Although many companies in the S&P 500 export goods and services to Europe, most of the demand from overseas in the past year has come from Asia. Large U.S. companies can still generate strong double-digit profit growth without help from Europe, he says.

Saturna's Nielsen is particularly eager to hear comments from pharmaceutical executives on earnings conference calls to get a sense of the impact they expect fiscal austerity measures in Europe to have on their European sales. He's deeply skeptical of the confidence sell-side analysts have in European governments' willingness to continue to pay up for drugs and joint replacements based on aging demographics in those countries, in the face of their fiscal difficulties.

Conference calls should also provide more clarity on the tangible costs of health-care and financial reform as companies disclose what they think the impact of these regulatory changes will be on their businesses, says Kleintop. "Once you can define them, they start to lose some of their potency to sway sentiment," he says. That could help sustain the recent stock rally. While the market seems stuck in a broad range, he says the S&P 500 could see further gains of 5 percent to 7 percent before another round of profit-taking kicks in.

The increasing number of downward earnings revisions doesn't bode well for stock market gains in 2010 relative to 2009. Roughly 200 companies in the S&P 500 have had downward revisions in the past three months, vs. 250 that have had upward revisions, according to data that Kleintop has been watching. Three months ago, only 150 companies had had downward revisions vs. 300 that had had upward revisions. The percentage of total analyst revisions that are positive "moves in lockstep with the year-over-year performance of the S&P [500 index]" going back 30 years, he says.

The steam that's come out of revenue growth expectations makes the 2011 consensus forecast for aggregate earnings of $96 per share for the S&P 500 look less and less realistic, says RiverSource's Joy. With the broad market now trading at around 12 times that number, even if you scale revenue growth back slightly, stocks still seem inexpensive, he says. That makes him think there's a cushion for equities even if revenue growth isn't robust enough to generate the earnings analysts are expecting.

Bogoslaw is a reporter for Bloomberg Businessweek's Finance channel.

http://www.businessweek.com/print/investor/content/jul2010/pi20100715_477248.htm

The Importance of Earnings Growth

Growth, overtrading and overcapitalization. Controlled and managed growth is critical to the future of a business.

Many businesses strive for growth.  There is a belief that fast growth is the best way to build a successful business.  However, is rapid growth the best option for business with relatively low cash and limited access to new external finance?



Overtrading

'Overtrading' is an imbalance between the work a business receives and its capacity to do it.  Overtrading is a symptom of fast-growing businesses, which chase sales and profitability at the expense of liquidity.

This is common in new businesses, which tend to offer long credit periods to customers in order to establish themselves in a new market.  At the same time many suppliers offer only short credit periods (or insist on cash payments) as the new business has no track record.  This gap between paying suppliers and receiving cash from customers is often financed via overdrafts.  Eventually overtraded businesses enter a negative cycle where banks will not extend their overdraft any further.  Growing interest costs and the associated debt means their financial status eventually reaches insolvency.  

"Yesterday is a cancelled check.  Today is cash on the line.  Tomorrow is a promissory note."



Overcapitalization

On the opposite end of the spectrum of overtrading is overcapitalization.  An overcapitalized business has excess assets, which are not being utilized effectively.  In essence it is not maximising returns in relation to the size of its assets and in particular its cash.  This is not so risky as overtrading but the money should be 

• used to finance long-term projects or 
• returned to shareholders.

Overcapitazation is often a symptom of a previously successful, mature businesses with minimal future growth prospects.



Finding the balance

It is difficult for a growing business to turn away sales, but success can kill a business as quickly as failure.

Controlled and managed growth is critical to the future of a business.

• Growth demands investment and only a certain level of growth can be financed by internally generated cash.  
• Further growth requires external investment and there's only so much money shareholders will commit and banks will lend in the short term.  

Growth in profits have LITTLE role in determining intrinsic value.

Growth in profits have LITTLE role in determining intrinsic value.  It is the amount of capital used that will determine value.  The lower the capital used to achieve a certain level of growth, the higher the intrinsic value.


Growth benefits investors only when the business in point can invest at incremental returns that are enticing - in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor."

If understood in their entirety, the above paragraph will surely make the reader a much better investor.

Growth in profits will have little role in determining value. It is the amount of capital used that will mostly determine value. Lower the capital used to achieve a certain level of growth, higher the intrinsic value.

There have been industries where the growth has been very good but the capital consumed has been so huge, that the net effect on value has been negative. Example - US airlines.

Hence, steer clear of sectors and companies where profits grow at fast clip but the return on capital employed are not enough to even cover the cost of capital.

Relating Price of Stock to its Earnings and Earnings Growth Rate

Here is an interesting way to think about your stock.  What do you think will be the price of Company A next year or 5 years from now? 

The obvious answer is no one knows.

However, one can in general, agree that if Company A grows its earnings, this will be reflected in a higher price of its stock.  Therefore to answer the question objectively, one would need to know exactly what will be company A's earnings for next year and in 5 years time.  As this is impossible, one can only guess or have a good 'hunch' about its future earnings.  Accordingly, there will always a speculative element in your estimates of future earnings when you invest in a stock.

Nevertheless, price of a stock is intimately linked to earnings.  When the company increases its earnings, this will be reflected in its share price also increasing.  However, short term volatility in price can be large and the price correlation with the earnings likewise volatile over the short term.  It is important for long term investors to know that the correlation between price and earnings over the long term is indeed very strong.  This relationship is to be exploited by the intelligent investors.

Therefore, when asked if the share price of Company A will double in 5 years from today, assuming that its present price is fair price, an appropriate answer might be be, definitely yes, IF it can double its earnings in 5 years.

For earnings to double in 5 years, the EARNINGS GROWTH RATE should be about 15% per year over these 5 years.  The company growing its earnings at lower than 15% per year is less likely to double its share price in 5 years from its fair price.  (Its share price may double at lower earnings growth rate if it started off severely undervalued.)   For example, a company with earnings growing at 7% per year is anticipated to see its share price doubled in 10 years.

On the other hand, a company growing its earnings at greater than 15% per year sustainably, will see its share price doubling in 5 years.  However, a company growing at high growth rates carries with it certain risks related to this fast growth.   Another paradox of a high earnings growth company is that its share price tends to be high due to popularity of the company amongst investors.  Therefore, though it may be a great company, it may not be a great investment if bought at very high price.

For those aiming for high returns in their investing, focusing on the quality of earnings and earnings growth (besides other business characteristics, risks and fundamentals) of a company, is important.  Is the company able to grow its business and earnings sustainably over many years?

Stock Valuation Model – 3 Simple Techniques to Value Stock

Stock valuation models are methods to value stocks. Everybody knows the stock price but only few understand how much it worth and the other investors do not even care. The reason can be due to different strategies, do not know how to value stock or just do not care how much it worth as long as the price increase the next day. If you are one of the intelligent investors, consider these valuation models in your next purchase.

Discounted Cash Flow (DCF)

This is probably the most common model that you ever heard when it comes to stock valuation. However, I found it a bit tough to do it. Simply because the discounted cash flow model have to consider revenue growth and the escalated cost at the same time, which can be too difficult to estimate and forecast as an outside investor.

Nevertheless, you can use this method in valuing stock by projecting future cash flow; from the sales and costs, and discount back to current value with Weighted Average Cost of Capital (WACC).

Dividend Discount Model (DD)

This model suits best for income investors. The idea is to project future dividend distribution based on the average historical dividend payout ratio and discount it back to present value. Although this is the simplest among all, it works best for high dividend yield stocks.

Nonetheless, the stocks must have very strong business performances that can guarantee the dividend payments 10 years down the road. And normally, penny stocks cannot be evaluated this way.

Earnings Growth Model (EG)

This is my favourite method as it is very practical and easy to do. Initially, I project its future earnings using constant or variable growth rate. Either constant or variable growth rate is depends on the expectation of its business performance within that period. Often than not, I normally use the historical business performance as a baseline provided its fundamental value remain intact. Then, I discount the future earnings with the expected return on investment (ROI).

I found this model as highly valuable since the stock price is easily reflected by its earnings. For example, the stock price will reflect its earnings and earnings growth. Assuming the P/E is the same throughout the year, you can expect the stock price to increase the same rate as the company’s growth rate.

So, before buying anymore shares in the future, put some efforts to value the stock. You can reduce the risk of losing money significantly if you buy the stock at much cheaper price than its intrinsic value.

http://mystocks.netai.net/4665/stock-valuation-model-3-simple-techniques-to-value-stock/

Every person who owns shares in a company wants it to grow

Every person who owns shares in a company wants it to grow

When investors talk about "growth", they're not talking about size.  They're talking about profitability, that is, earnings.

It means the profits are growing.  The company will earn more money this year than last year, just as it earned more money last year than the year before that.

• A company doubling its earnings in 12 months can cause a wild celebration on Wall Street, because it's very rare for a business to grow that fast.
• Big, established companies are happy to see their earnings increase by 10 to 15% a year, and
• younger, more energetic companies may be able to increase theirs by 25 to 30%. 

One way or the other, the name of the game is earnings.  That's what the shareholders are looking for, and that's what makes the stocks go up.

People who buy shares are counting on the companies to increase their earnings, and they expect that a portion of these earnings will get back to them in the form of higher stock prices.

This simple point - that the price of s stock is directly related to a company's earning power - is often overlooked, even by sophisticated investors. 

The earnings continue to rise, the stock price is destined to go up.  Maybe it won't go up right away, but eventually it will rise.

And if the earnings go down, it's pretty safe bet the price of the stock will go down.  Lower earnings make a company less valuable.

This is the starting point for the successful stockpicker.  Find companies that can grow their earnings over many years to come. 

It is not an accident that stocks in general rise in price on average of about 8% a year over the long term.  That occurs because companies in general increase their earnings at 8% a year, on average, plus they pay 3% as a dividend.

Based on these assumptions, the odds are in your favour when you invest in a representative sample of companies.  Some will do better than others, but in general, they'll increase earnings by 8% and pay you a dividend of 3%, and you'll arrive at your 11% annual gain.


Stock Price Watchers

The ticker-tape watchers begin to think stock prices have a life of their own.

• They track the ups and downs, the way a bird watcher might track a fluttering duck.
• They study the trading patterns, making charts of every zig and zag.
• They try to fathom what the "market" is doing, when they ought to be following the earnings of the companies whose stocks they own.

"Expensive Shares"

By itself, the price of a stock doesn't tell you a thing about whether you're getting a good deal.


You'll hear people say: "I am avoiding IBM, because at $100 a share it's too expensive." 

• It maybe that they don't have $100 to spend on a share of IBM, but the fact, that a share costs $100 has nothing to do with whether IBM is expensive. 
• A $150,000 Lamborghini is out of most people's price range, but for a Lamborghini, it still might not be expensive. 

Likewise, a $100 share of IBM may be a bargain, or it may not be.  It depends on IBM earnings.

• If IBM is earning $10 a share this year, then you're paying 10 times earnings when you buy a share for $100.  That's a P/E ratio of 10, which in today's market is cheap. 
• On the other hand, if IBM only earns $1 a share, then you're paying 100 times earnings when you buy that $100 share.  That's a P/E ratio of 100, which is way too much to pay for IBM.

Understanding Sales Growth

In general, sales growth stems from one of four areas:

 

1. Selling more goods and services

The easiest way to grow is to do whatever you're doing better than your competitors, sell more products than they do, and steal market share from them.

2. Raising prices

 

Raising prices can also be a great way for companies to boost their top lines, although it takes a strong brand or a captive market to be able to do it successfully for very long. 

 

3. Selling new goods or services

If there's not much more market share to be taken or your customers are very price-sensitive, you can expand your market by selling products that you hadn't sold before.  Investigate new markets.

 

4. Buying another company

 

The fourth source of sales growth - acquisitions - deserves special attention.  Unfortunately, the historical track record for acquisitions is mixed.  Most acquisitions fail to produce positive gains for shareholders of the acquiring firm, and one study showed that even acquisitions of small, related businesses - which you'd think would have a good chance of working out well - succeeded only about half the time.

 

 

For the investor, the goal of this type of analysis is simply to know why a company is growing. 

For example, in a beer company, you would want to know

• how much growth is coming from price increases (more expensive beer),
• how much is coming from volume increase (more beer drinkers), and
• how much is coming from market share growth (more company's brand drinkers). 

Once you're able to segment a firm's growth rate into its components, you'll have a much better handle on where that growth is likely to come from in the future - and when it may tap out.

High growth rates are heady stuff and not very persistent over a series of years

The allure of strong growth has probably led more investors into temptation than anything else. 

High growth rates are heady stuff - a company that manages to increase its earnings at 15% for 5 years will double its profits, and who wouldn't want to do that?

Unfortunately, a slew of academic research shows that strong earnings growth is NOT VERY PERSISTENT over a series of years; in other words, a track record of high earnings growth does not necessarily lead to high earnings growth in the future. 

Why is this?

• Because the total economic pie is growing only so fast - after all, the long-run aggregate growth of corporate earnings has historically been slightly slower than the growth of the economy - strong and rapidly growing profits attract intense competition. 
• Companies that are growing fast and piling up profits soon find other companies trying to get a piece of the action for themselves.

Whose Growth rate to use in PEG calculations?

Whose Growth rate?

In computing PEG ratios, we are often faced with the question of whose growth rate we will use in estimating the PEG ratios.

If the number of firms in the sample is small, you could estimate expected growth for each firm yourself.

If the number of firms increases, you will have no choice but to use analyst estimates of expected growth for the firms. Will this expose your analyses to all of the biases in these estimates? Not necessarily. If the bias is uniform – for instance, analysts over estimate growth for all of the firms in the sector – you will still be able to make comparisons of PEG ratios across firms and draw reasonable conclusions.

http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf

Earnings Growth, Earnings Yield and PEG

PEG relates, or normalizes, the PE to the growth rate.

• With PEG, apparently high PE ratios are supported by forward growth.
• PEG thus becomes a better tool to compare stocks with different PEs and different underlying growth assumptions.

By itself, it's hard to tell whether a PE is good or bad.

A stock with a PE of 30 may be a better deal than another stock with a PE of 15. Why? Because of growth.

• A stock of a no-growth company with a PE of 15 will never achieve an earnings yield beyond 7.5% (1/15).
• Meanwhile, the company with a PE of 30, with a growth rate of 20%, eventually achieves an earnings yield greater than 20%.

Enter the practice of normalizing PE by the growth rate.

• To do that, we divide all PEs by the company's growth rate to create a ratio known as (Price/earnings)/growth, or PEG for short.
• G is the growth rate, expressed as a whole number (that is, the percentage times 100).
• So, a company with a PE of 30 and a growth rate of 20% has a PEG of 1.5.

This gives a standard for comparison.

• Company A with a PE of 18 and a growth rate of 12% has the same PEG as Company B with a PE of 30 and a growth rate of 20%.
• Are the two PEs the same? 30 versus 18?
• Clearly not - until the underlying growth fundamentals are identified, apply PEG, and find out they are indeed priced equally.

The table below shows the relationship between future earnings yield, PE, and PEG. Watch what happens to PEG and future earnings yields as growth assumptions rise.

http://spreadsheets.google.com/ccc?key=toPlORpn7n23_xeRq2vYALQ

Low PEG ratios (less than 2) correspond to high future earnings yields.

You can see:

PEG = 2 scenario corresponds to a future earnings yield of 13%.
PEG = 1.30 correlates to 20%, and,
PEG = 1 correlates to a future earnings yield of 31% on today's investment price.

On the other hand, if:

PEG = 4, the implied future earnings yield is only 8.1%.

So, what is a "good" PEG ratio?

It all depends on the implied future rate of return you're looking for, which depends on

• (1) investment objectives,
• (2) risk tolerance, and
• (3) current risk-free (bond) interest rates.

A PEG of 2.7 or less: implies a future earnings yield of 10% or more.

A PEG of 2.7 or more: implies a future earnings yield of 10% or less. This is probably less return at more risk than most investors desire.

As a guide:

A PEG of 1 or less: this is great (but hard to find)

A PEG between 1 and 2: this is good.

A PEG between 2 and 3: this is marginal.

A PEG over 3: should probably be avoided.