The Alchemy of Stock Market Performance - Total Returns to Shareholders

Total Returns to Shareholders

Decomposing total returns to shareholders (TSR) can give better insights into a company's true performance and in setting new targets.

The traditional method decomposes TRS into three parts:

1. percent change in earnings
2. percent change in P/E, and, 
3. dividend yield.

A clearer picture can be found from breaking TRS into four parts:

1. the value generated from revenue growth net of the capital required to grow
2. the growth in TRS that would have taken place without the measure in (1),
3. changes in shareholder's expectations about the company's performance as reflected in a measure such as P/E, and
4. the effect of leverage.

A good company and a good investment may not be the same.

Example:

Comparing the company and stock performance of Reckitt Benckiser Group (RB) and Henkel from 2008 to 2013

Revenue growth and ROIC:   RB outperformed Henkel in both

Annualised TRS:  RB 19% and Henkel 932%)

Explaination:  Henkel's low starting multiple in 2008 reflected difficulties with its adhesives business, which experienced significant declines in sales volume in 2008 and 2009.




Expectation treadmill

This is the name for a problem faced by high-performing managers who try to meet market expectations that result from the high level of performance in recent periods.

RB above, illustrates the reason that, in the short term, extraordinary managers may deliver only mediocre total returns to shareholders.

Lesson derived (for investors and managers):  A small decline in TRS in the short run to adjust expectations (P/E) may be preferable to desperately trying to maintain TRS through acquisitions and ill-advised ventures.



Summary:

For periods of 10 - 15 years or more, it is true that if managers focus on improving TRS to win performance bonuses, then their interests and the interests of shareholders should be aligned.

The detrimental result of the expectations treadmill is that, for firms that have had superior operating and TRS performance, the managers who try to continually meet the higher expectations may engage in detrimental activities such as ill-advised acquisitions or new ventures.

A company should measure management performance in terms of the company's performance, not its share price.

Three areas of focus should be its performance relative to its peers in its::

• growth,
• ROIC, and 
• TRS,

Be conservative in your estimates for future growth.

Never estimate future earnings growth:

• to exceed the growth of sales
• to exceed 20 percent
• to exceed its historical growth rate
• to exceed the analysts' estimates.

Be conservative in your estimates for future growth.  It's always better to underestimate than to overestimate.

Confine your study to companies with good sales or earnings growth.

Don't bother to continue with a stock study if sales or earnings growth is inadequate.

Sales growth is inadequate if it is below the guidelines for the size of the company you are studying (ranging from around 7 percent for a large company to 12 percent for a smaller one).

Earnings growth should be around 15 percent or better; but you can accept slower growth from companies whose dividends contribute substantially to the total return.

The Technique of Fundamental Analysis

Fundamental analysts believe that the market is 90% logical and only 10% psychological.  Value is related to a company's assets, its expected growth rate of earnings and dividends, interest rates, and risk.  By studying these factors, the fundamentalist arrives at an estimate of a security's intrinsic value or firm foundation of value.

Fundamentalists believe that eventually the market will reflect the security's real worth.

The fundamentalist strives to be relatively immune to the optimism and pessimism of the crowd and makes a sharp distinction between a stock's current price and its true value.

In estimating the firm-foundation value of a stock, the fundamentalist's most important job is to estimate the firm's future stream of earnings and dividends.  The worth of a share is taken to be the present or discounted value of all the cash flows the investor is expected to receive.  The analyst must estimate the firm's sales level, operating costs, tax rates, depreciation, and the sources and costs of its capital requirements.

The fundamentalist uses four basic determinants to help estimate the proper value for any stock.

1.  The expected growth rate.
Rule:  A rational investor should be willing to pay a higher price for a share the larger the growth rate of dividends and earnings.
Rule:  A rational investor should be willing to pay a higher price for a share the longer an extraordinary growth rate is expected to last.

2.  The expected dividend payout.
Rule:  A rational investor should be willing to pay a higher price for a share, other things being equal, the larger the proportion of a company;s earnings that is paid out in cash dividends.

3.  The degree of risk.
Rule:  A rational (and risk averse) investor should be willing to pay a higher price for a share, other things being equal, the less risky the company's stock.

4.  The level of market interest rates.
Rule:  A rational investor should be willing to pay a higher price for a share, other things being equal, the lower the interest rates.


The above valuation rules imply that a security's firm-foundation value (and its price-earnings multiple) will be higher 

• the larger the company's growth rate and the longer its duration;
• the larger the dividend payout for the firm; 
• the less risky the company's stocks; and 
• the lower the general level of interest rates.

In principle, such rules are very useful in suggesting a rational basis for stock prices and in giving investors some standard of value.  But before using these rules, bear in mind the following caveats.

1.  Expectations about the future cannot be proven in the present.

Predicting future earnings and dividends is a most hazardous occupation.  It is extremely difficult to be objective; wild optimism and extreme pessimism constantly battle for top place. "Forecasts are difficult to make - particularly those about the future."

2.  Precise figures cannot be calculated from undetermined data.

There is always some combination of growth rate and growth period that will produce any specific price.  In this sense, it is intrinsically impossible, given human nature, to calculate the intrinsic value of a share.  

The point to remember is that the mathematical precision of fundamental value formulas is based on treacherous ground: forecasting the future.  "God Almighty does not know the proper price-earnings multiple for a common stock."

3.  What's growth for the goose is not always growth for the gander.

It is always true that the market values growth, and that higher growth rates and larger multiples go hand in hand.  But the crucial question is:  How much more should you pay for higher growth?  

There is no consistent answer.  In some periods, the market was willing to pay an enormous price for stocks exhibiting high growth rates.  At other times, high growth stocks commanded only a modest premium over the multiples of common stocks in general.   Growth can be as fashionable as tulip bulbs, as investors in growth stocks painfully learned. 

From a practical standpoint, the rapid changes in market valuations that have occurred suggest that it would be very dangerous to use any one year's valuation relationships as an indication of market norms.  However, by comparing how growth stocks are currently valued with historical precedent, the investor should at least be able to isolate those periods when a touch of the tulip bug has smitten investors.

Why might fundamental analysis fail to work?

There are three potential flaws in this type of analysis.
1.  The information and analysis may be incorrect.
2.  The security analyst's estimate of "value" maybe faulty.
3.  The market may not correct its "mistakes", and the stock price may not converge to its value estimate.

Corporate Finance - Earning Growth Rate and Dividend Growth Rate

 Calculating a Company's Implied Dividend Growth Rate

Recall that a company's ROE is equal to a company's earnings growth rate (g) divided by one minus a company's payout rate (p).

Example:Let's assume Newco's ROE is 10% and the company pays out roughly 20% of its earnings in the form of a dividend. What is Newco's expected growth rate in earnings?

Answer:g = ROE*(1 - p)
g = (10%)*(1 - 20%)
g = (10%)*(0.8)
g = 8%

Given an ROE of 10% and a dividend payout of 20%, Newco's expected growth rate in earnings is 8%.

Read more: http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/dividend-growth-changing-dividend-policy-effects.asp#ixzz1yf57n9sb

Impact of Retained earnings on EPS

When EPS growth is entirely due to profits from retained earnings, the increased EPS percentage measures the impact of ROE on those retained earnings. 

For instance,

Half of profit is retained: If ROE is 20 percent, half the profit is retained and ROE in the following year remains steady at 20 percent, EPS will increase by 10 percent.

All profit is retained: If all profit is retained and reinvested at 20 percent, EPS will increase by 20 per cent. 

All profit is distributed: If all profit were distributed, irrespective of ROE, EPS growth would be zero.

Investors In Common Stocks Must Get Valuation Right; Here’s How

By Chuck Carnevale

Mar 09, 2012 04:54AM GMT

Chuck Carnevale

 

The investment industry is replete with pundits and self-proclaimed experts espousing various principles and rules that allegedly are the best way to value a stock correctly. Unfortunately, and in most cases, these rules are stated as fact, but unfortunately very few facts are ever presented to back them up.  In other words, much of it is either opinion or gleaned from something they’ve read or been taught before.  But even as a young boy, I was never willing to accept dogma as fact without simultaneously being provided supporting evidence and a logical explanation as to the “why” that they work.

In fifth grade I was once sent to the principal’s office by my English teacher because I made her cry.  She cried because every time she would regurgitate a rule of grammar, punctuation or spelling, she expected me to accept it unconditionally, merely because she said so.  For example, she would say something like I before E except after C expecting me to simply accept this rule as fact. I, on the other hand, not meaning to be argumentative or disruptive, only inquisitive, would immediately raise my hand in class and ask a simple question-why? No matter what rule she would state, I would relentlessly raise my hand and ask okay, but why?  I was not willing to have the rule dictated to me; I needed to understand why it was the rule and why it was important.

Now that I am an adult, I have continued to embrace my inquisitive nature, and to this day I will not accept a dogmatic statement without understanding why.  On the other hand, when I can review supporting evidence that validates the rule and therefore understand its significance, relevance and validity, then and only then, through my understanding it, can I embrace it willingly and passionately.  Therefore, as an author of financial articles, I believe my readers should hold me to this same standard that I hold others to.  Consequently, this article is designed to illuminate the “why” behind widely accepted notions of valuing a business primarily based on earnings (discounting cash flows).

When Investing in a Business Earnings Determine Intrinsic Value

In his best-selling book One Up On Wall Street, famed portfolio manager Peter Lynch dedicated his entire 10th chapter to earnings and thus titled it –Earnings, Earnings, Earnings. In the chapter’s second paragraph he succinctly stated the importance of earnings as follows:

“There are many theories, but to me, it always comes down to earnings and assets.  Especially earnings.  Sometimes it takes years for the stock price to catch up to a company’s value, and the down periods last so long that investors begin to doubt that it will ever happen. But value always wins out-or at least in enough cases that it’s worthwhile to believe it.”

An important foundational principle behind this discussion is the idea that we are talking about investing as part owners of strong businesses, rather than trading stocks.  Business owners are rewarded through the profits the companies they own are capable of generating on their behalf. These rewards can come in the form of salaries and bonuses for active owners, and from increasing value or cash flow from dividends for passive shareholders. In either event, all these rewards are ultimately a function of the businesses’ earnings capability, at least in the longer run.  Therefore, we should realize that when you truly invest in a stock, you really are investing in its ability to earn more money for you in the future.

When I first read Peter Lynch’s famous book in 1990, I had already developed a strong belief in the importance of earnings regarding assessing the fair value of an operating business.  Therefore, the theory behind Peter Lynch’s wisdom already resonated deep within me.  However, as already stated, it was the facts behind the theory that interested me the most. In fact, I was so committed to the notion that earnings determine market price, that I developed my own stock graphing tool that allowed me to evaluate the true relationship between a company’s earnings and its stock price over time.

The following additional quotes from Chapter 10 of Peter Lynch’s book titled: Earnings, Earnings, Earnings, speak to the importance of valuing a business based on its earnings power:

“you can see the importance of earnings on any chart that has an earnings line running alongside the stock price….  On chart after chart the two lines will move in tandem, or if the stock price stays away from the earnings line, sooner or later it will come back to earnings.”

A few pages later, Peter offers us another nugget of wisdom on the earnings and price relationship, plus a little bit of investing advice thrown in:

“a quick way to tell if a stock is overpriced is to compare the price line to the earnings line……. If you bought familiar growth companies…… when the stock price fell well below the earnings line, and sold them when the stock price rose dramatically above it, the chances are you would do pretty well.”


Now that we’ve reviewed some investing axioms and nuggets from Mr. Peter Lynch, let’s see if we can perform two extremely important tasks. 

• First and most importantly, let’s see if we can answer the more important question as to why earnings determine market price; not just that it does. 
• Next, let’s produce some evidence that verifies the veracity of Mr. Peter Lynch’s words. 

In order to accomplish both of these important tasks we will rely on visual representation, and mathematical proofs provided by F.A.S.T. Graphs™. 

How to Value a Company’s Earnings and Why

The essential point underpinning the thesis of this article, is that when you’re investing in a business you’re not actually buying the stock, you’re buying the company’s earnings power.  The stock is only the vessel that contains the earnings you are purchasing.  When buying earnings, the principles of value apply just like they do with any other product or service. The easiest way to understand this clearly, is to think in terms of the price you pay to buy $1 dollar’s worth of one company’s earnings versus $1 dollar’s worth of another company’s earnings.

In other words, let’s look at two companies to see what the price, and therefore, value, of $1 dollar’s worth of earnings are. However, before we do, let’s establish some doctrine that we are going to focus on. First and foremost, remember that we are going to buy $1 dollar’s worth of earnings for each of our two companies.  Now, we need to clearly understand that once either of those dollar’s worth of earnings are taken out of the business and put into our pockets, the value of each dollar’s worth of earnings is precisely the same. When separated from the business, a dollar is a dollar, and a dollar from one company will buy no more or no less than a dollar from another company.

However, we also have to deal with the fact that $1 dollar’s worth of each respective company has a different cost.  This then begs the question, why? 

• In other words, why would we pay more to buy company A’s dollar worth of earnings than we would to buy Company B’s dollar worth of earnings? 
• Since a dollar’s worth of each company’s earnings once received outside of the business is worth exactly the same, why would we pay more to buy one of the dollars than the other?

The reason, as we will develop more fully later, is that if we are long-term investors in businesses, we are actually buying future earnings, not current earnings. Therefore, the amount of earnings we accumulate in the future will be a function of the company’s earnings growth rate, and will determine what price we paid today to buy those future earnings of tomorrow. Let’s clarify this by examining the dynamics of our two example companies. We will start with history presented as evidence of what has actually already happened, and then we will move on to the future, which we believe is actually more relevant.

Our first example is Sherwin-Williams Co. (SHW), which has achieved a historical earnings growth rate of 9.6% since 1999. At the bottom of the graph you can see that earnings have grown from $1.81 per share in 1999, to an estimate of $5.67 per share for fiscal 2012 (see yellow highlighted earnings at the bottom of the graph).  This represents approximately a three-fold increase in earnings over the past 14 years. The primary point is that every $1 dollar’s worth of earnings you bought in 1999, are now worth approximately $3 dollars. Another way to put this is that Sherwin-Williams’ future dollars in 2012 only cost one third as much as the original $1 dollars worth of earnings cost in 1999.

 SHW Chart 1

Our second example, CSX Corp. (CSX), grew earnings per share at the higher rate of 12.9% since calendar year 1999.  Therefore, earnings per share grew from $.26 a share in calendar year 1999 to $1.86 per share estimated for fiscal year-end 2012 (see yellow highlighted earnings at the bottom of the graph). This is approximately a seven-fold increase in earnings per share over this 14-year period. The primary point is that every $1 dollar’s worth of earnings you bought in 1999, are now worth approximately $7 dollars. Consequently, shareholders that bought CSX in 1999 only paid 1/7th of the original price for calendar year 2012 earnings.  In other words, due to the company’s historical earnings growth rate, future earnings were significantly cheaper than original earnings. As we will discover next, herein lays the essence of fair value, or what others call intrinsic value of a business (common stock).

 CSX 1

Now let’s move to current time to examine what price we have to pay to buy $1 dollar’s worth of each of our example company’s earnings today, and attempt to calculate what $1 dollar’s worth of future earnings are actually costing us. The metric that establishes that price is the common PE ratio.  One of the definitions of the PE ratio is: The price you pay to buy $1 dollar’s worth of a company’s earnings.  Remember though, we are pricing $1 dollars worth of today’s earnings, even though in actuality what matters most is the price we’re paying to buy $1 dollars worth of future earnings.

In the case of Sherman-Williams (SHW), today we are asked to pay $20.90 (current PE ratio 20.9 see red circle at right of graph ) to buy our $1 dollar’s worth of current earnings.  As an aside, you can note from the graph that this is the highest valuation or price that you were asked to pay to buy a $1 dollar’s worth of Sherwin-Williams’ earnings since 1999.  In other words, Sherwin-Williams’ stock appears very expensive today based on historical earnings growth.

 SHW 2

In the case of our second example, CSX Corp. we discover that we are only being asked to pay $11.90 (current PE 11.9 see orange circle at right of graph) to buy $1 dollar’s worth of CSX Corp.’s current earnings. This is almost half the price we are being asked to pay to buy an equivalent $1 dollar’s worth of Sherwin-Williams Co.’s earnings. Therefore, the rational investor should ask this simple question:  Why should I be willing to pay almost twice as much to buy Sherwin-Williams’ earnings as I’m being asked to buy CSX’s earnings? The only logical answer would be because future earnings are expected to be much higher for Sherwin-Williams Co. than for CSX Corp. But in fact, this is not true, and as we will next illustrate, the real answer doesn’t make any mathematical sense.

 CSX 2

Utilizing the Estimated Earnings and Return Calculator we discover that the consensus (15 analysts reporting to Capital IQ) estimate earnings growth rate for Sherman-Williams at a very strong 13.1%. This calculates out that expected calendar year 2017 earnings of $10.64 will be approximately twice as large as 2011’s earnings of $4.95.  Therefore, we are, in theory at least, only paying approximately $10 today to buy a future $1 dollar’s worth of Sherwin-Williams’ 2017 earnings.  In other words, the PE ratio of the future earnings we are buying is approximately 10, or half of what we have to today pay for current earnings.

 SHW 3

Once again, utilizing the Estimated Earnings and Return Calculator we discover that the consensus (26 analysts reporting to Capital IQ) expect CSX Corp. to grow earnings at a very strong rate of 14%. This calculates out that CSX Corp.’s expected earnings in 2017 will also be approximately 2 times larger than today’s earnings of $3.63 in 2017 versus the original $1.67 in 2011.  To be clear, this means that the earnings growth rates in both of our sample companies are expected to be essentially the same or at least similar.

Most importantly, it also means that we are only paying a PE of 5.6 to buy CSX Corp.’s $1 dollar’s worth of future earnings (2017) versus paying a PE of 10 for Sherwin-Williams’ $1 dollar’s worth of future earnings (2017). As we’ve previously established, if we received $1 dollar’s worth of dividends from both companies, each would be able to buy no more or no less goods or services than the other.  So once again we ask the question; why would we want to pay twice as much to buy $1 dollar’s worth of Sherwin-Williams’ future earnings as we would to buy CSX Corp.’s? Logically, it makes no sense, yet many investors do it every day.

 CSX 3

In the two examples used in our analogy above, we identified two companies with somewhat similar historical growth rates, but more importantly with almost identical expectations for future growth.  Consequently, logic should dictate that both companies should be priced at approximately the same valuations.  The examples utilized, neither company has a real edge over the other company regarding earnings power. Therefore, why should the one, Sherwin-Williams Corp., have an edge in market price over the other, CSX Corp.? The straightforward answer; there is no rational reason.

It’s also important to recognize that the market does not always price common stocks according to their fair value.  In fact, at any moment in time, the market can be mispricing the value of common stocks by significant degrees.  This is why the venerable Ben Graham gave us his famous metaphor: “in the short run the market is a voting machine, but in the long run it’s a weighing machine.”  This is the same lesson that Peter Lynch offered in the above referenced quote where he talks about value eventually winning out.  Shrewd investors know how to calculate fair value, and therefore, are capable of avoiding what is often the obvious mistake of paying too much.  On the other hand, shrewd investors also recognize a bargain when they see one.
Furthermore, it should also be understood that there are valid reasons to pay more for one company than for another.  However, those reasons have to be mathematically sound and, therefore, make economic and prudent sense.  For example, thanks to the power of compounding; a company with a very high growth rate of 20% to 30% or more would obviously be worth more than a company only growing at 10% or 15%.

• The point is that the faster growing company would be capable of generating significantly more future earnings than the slower growing one.  
• Therefore, even though you pay more today to buy the faster grower, you can actually be buying future earnings cheaper, again, thanks to the power of compounding.

Summary and Conclusions

The moral of the story is simply that investors should be careful and willing to always run the numbers out to their logical conclusions. But, it all starts with knowing what you are buying (investing in) in the first place.  True investors, like Peter Lynch, and many of the other renowned investing greats such as Phil Fischer, Warren Buffett, etc., all invest as owners in businesses with a focus on the strength of the business behind the stocks they buy. Therefore, these investor greats are always buying the earnings power of the respective businesses they are investing in, relative to their goals and objectives.

These principles of valuation apply equally to growth stocks as they do dividend stocks.  When applied to growth stocks,

• investors need to understand that the more future earnings they can buy today at a good price, means more future earnings that the market can capitalize in the future.  
• Since this is their only source of return, the more future earnings they can amass the more value or return they can expect.  
• Fast growth does typically come at a higher price, but simultaneously it needs be understood that faster growth, if it occurs, also generates a bigger pile of future earnings. 
• And, as this article has illustrated, it’s the future earnings that ultimately drive fair value.

When applied to dividend paying stocks, the principle is just as valid, and maybe easier to see.  

• Since the company is going to pay dividends, the dividend investor is going to receive some of the company’s earnings in cash outside of the business.  
• As I illustrated above, when they go to spend $1 dollar’s worth of dividends from Company A versus $1 dollar’s worth of dividends from Company B, each $1 dollar’s worth of dividends will have the same value outside of the business.  
• Therefore, it only logically follows that both of those dollars should have the same value while they are still in the business.

Importantly, a few words on the differences between investing and speculating are perhaps in order. 

Active traders will not find any value in this discussion, because

• active traders usually don’t own a company long enough to think about earnings power at all.  
• Active traders are only really interested in momentum and volatility.  
• They are “the voting machine” segment of the market. 
• This is a primary reason why stocks can become improperly or unrealistically valued by Mr. Market, the voter; however, there are others reasons that we will leave to future discussions. 
• Additionally, to be a trader requires a continuous commitment to watching every little price tick of the market, which is beyond the interest of most people that are investing for their future economic benefit.

True investors are interested in 

• building long-term positions in great businesses bought at rational prices. 
• It is to this segment of the financial community that this article is geared to. 
• Frankly, we believe this is the largest segment of the market comprised of prudent investors that have other things to do with their time than watching the bouncing ball of often frivolous stock price movements.  
• These true investors need to understand the principles of valuation presented in this article if they are going to achieve their financial goals while simultaneously doing so at reasonable levels of risk.

Based on this discussion, of the two companies utilized as examples in this article, the principles of valuation would indicate that one is a buy and one is a sell. We believe that both of these companies are excellent candidates that when appropriately priced (valued) would make great additions to almost any long-term investors portfolio.  However, if the expected future growth rates are accurate, then Sherwin-Williams is clearly overpriced, while CSX Corp. looks like a great bargain today.  Of course, all prospective investors are encouraged to perform their own due diligence before taking any action.

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

http://www.forexpros.com/analysis/investors-in-common-stocks-must-get-valuation-right;-here%E2%80%99s-how-116410

WHAT WARREN BUFFETT LOOKS FOR IN COMPANY GROWTH

An investor likes to see a company grow because, if profits grow, so do returns to the investor. The important thing for the investor, however, is that the company increases the returns to shareholders. A company that grows, at the expense of shareholder returns, is not generally a good investment. As Warren Buffett said in 1977:

‘Since businesses customarily add from year to year to their equity base, we find nothing particularly noteworthy in a management performance combining, say, a 10% increase in equity capital and a 5 % increase in earnings per share.’

WARREN BUFFETT AGAIN ON GROWTH

For Warren Buffett the important thing is not that a company grows (he points to the growth in airline business that has not resulted in any real benefits to stockholders) but that returns grow. In 1992, he said this:

‘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.’

ROE and Internet Stocks

As an example, consider the fastest growing segment of 1999, Internet stocks.

Most Internet companies are growing rapidly, but few of them are generating profits.



Apart from America Online AOL and its 25% ROE in 1999, none have generated a high return on capital. 


In 1999, the ROE for market darling Amazon.com AMZN was negative 270%.

• In other words, for each dollar shareholders had invested in the company, Amazon lost $2.70.  
• To replenish the lost capital, the company must either issue debt or turn to shareholders for more money -  and there are still plenty of people willing to pony up the money to own a piece of Amazon.  
• If Amazon is going to justify its price, it will eventually have to generate good returns on capital, and whether it can do that depends on which pundits you listen to.  

But there is no argument that returns on capital are the engine that drives stock prices in the long run.


Companies that go on to earn good returns on capital - ROEs of more than 15% or 20% - will probably make good investments.   

Those that struggle to earn a decent return will probably be wretched investments, regardless of how fast they grow.  

So, if someone tries to talk you into investing $10,000 in a restaurant or a few hundred share of an Internet stock, don't ask how fast the company will grow.  Ask how the heck it is going to earn a good return on its capital.

What do you need to beat the market? Higher mathematical expectancy

What do you need to beat the market?  

You need to pick stocks of companies that have a higher mathematical expectancy than that of the market, example, the S&P 500. 

Of course, this could come in many forms, for example:

- a higher earnings yield (low PE), 

- better growth prospects (high EPS growth rate), 

- higher certainty in the company’s future prospects (good quality business and management), or 

- a cheaper stock price in relation to the business’s underlying assets (undervalued stock).  

Understanding Earnings per Share and its Impact on Stock Price

Understanding Earnings per Share and its Impact on Stock Price
BY STOCK RESEARCH PRO • MAY 9TH, 2009

A company’s Earnings per Share (EPS) represents the portion of the company’s earnings (after deducting taxes and preferred share dividends) that is distributed to each share of the company’s common stock. The EPS measure gives investors a way to compare stocks in an “apples to apples” way.

The Importance of Earnings per Share in Evaluating Stocks
Fundamental stock evaluation revolves primarily around the earnings a company generates for its shareholders. Earnings, of course, represent what the company makes through its operations over any particular period of time. While smaller, newer companies may have negative earnings as they establish themselves, their stock prices will reflect future earnings expectations. Larger companies are judged mainly on the earnings measure. Decreased earnings for these companies are likely to negatively impact their stock prices.

The Earnings Cycle
Earnings are reported every calendar quarter with the process beginning shortly after the end of a fiscal quarter (a three month period).

Calculating Earnings per Share
The formula for earnings per share can be written as:

(Net Income – Preferred Stock Dividends) / Average Outstanding Shares

Because the number of shares outstanding can fluctuate over the reporting term, a more accurate way to perform the calculation is to use a weighted average number of shares. To simplify the calculation, though, the number used is often the ending number of shares for the period.

Investors can then divide the price per share by the earnings per share to arrive at the price to earnings ratio (P/E Ratio) or “multiple”. This ratio gives us an indication of how much investors are willing to pay for each dollar of earnings for any particular company.

Basic v. Diluted Earnings per Share
In calculating the EPS, one of two methods can be used:
Basic Earnings per Share: Indicates how much of the company’s profit is allocated to each share of stock.
Diluted Earnings per Share: Fully reflects the impact the firm’s dilutive securities (e.g. convertible securities) may have on earnings per share.

Types of Earnings per Share
EPS can be further subdivided into various types, including:
Trailing EPS: Calculated based on numbers from the previous year
Current EPS: Includes numbers from the current year and projections
Forward EPS: Calculated based on projected numbers
Please note that most quoted EPS values are based on trailing numbers.

http://www.stockresearchpro.com/understanding-earnings-per-share-and-its-impact-on-stock-price

Bullbear Stock Investing Notes
http://myinvestingnotes.blogspot.com/

Valuation based on EPS, EPS GR and PE

http://bigmoatstocks.com/bigmoat-spreadsheet/

Comparing the P/E to Growth Rates

Answer:

Company A's forward P/E is 7.5, while Company B's remains 7.

Remember, you are more concerned with what Company A is going to do - keep growing while Company B has apparently run out of gas - than what it has already done, and you don't want to pay nearly the same amount for no earnings growth as you would for a nice 15% growth of Company A.


The above is the answer to the question posed here:

Comparing P/E ratios to growth rates can be significantly more useful than simply comparing two companies' P/E ratios. Why?

Role of Earnings in Investment decisions

 

Role of Earnings in Investment decisions

 

Once you have got an understanding of Income statement, you are ready to be your own analyst. Each quarter, companies release their earnings, and, for companies using the traditional calendar-year approach, the quarter ended on New Year's Eve. Earnings season is a great time to re-evaluate your current holdings to make sure the companies you own are living up to your expectations. But before earnings are even announced, you might want to review why you made the investment in the first place.

 

Whenever you buy a stock, write down in three or four sentences why you are doing so. State your reasons as objectively as you can. You might want to list such items as

• revenue growth,
• sustainability of earnings or growth over time,
• increased market share,
• increased gross margins,
• price targets for the stock or
• any other reasons you have for making the investment.

For example, you might write, "I am buying XYZ Corp. because I think earnings will grow at a rate of 20% per year and that the price/earnings multiple will increase from its current level of 16 to between 22 and 25."

 

By writing down your assumptions and your goals, you'll create a benchmark that can help you see over time how the company is performing. If you've never done this in the past, you might want to start now.

 

Now take a look at the earnings. The earnings per share (EPS) number is a good place to start. The EPS is the total net profit of the company divided by the number of shares of stock outstanding. But don't just look at the actual EPS and compare it to the expected EPS. Pull out your calculator and crunch some numbers.

 

First of all, has the number of shares outstanding changed significantly?

• Has the company bought back a large chunk of its stock?
• If so, earnings may have improved on a per-share basis, but may have stayed flat or even declined in real terms.

Next, you should be on the lookout for any one-time charges. You will want to remove the effect of the one-time charge, as it only creates noise and makes year-over-year comparisons more difficult.

• Any one-time charge or gain will be stated in per-share amounts as a footnote. Just subtract it from the EPS if it is a gain, or add it back if it is a loss.
• Once you have the EPS number exclusive of one-time items, you can compare it to the EPS from the same quarter last year to see how much growth has occurred.
• Compare the growth figure of your company to others in the same industry.

 

Once you have gotten a good feel for the EPS, it's time to look at the actual numbers on the income statement. Here are some questions to ponder while you have your calculator in hand.

• What does the growth rate in sales look like?
• How was it last quarter?
• Are gross margin percentages better or worse than they have been historically?
• Are expenses increasing faster than sales?

 

Using your written benchmarks for the stock, create a couple of additional questions to help you compare the company's results with your own stated assumptions.

 

 

http://www.karvy.com/buysell/incomestatement.htm

Companies with different EPS GR bought at different prices

Conclusion:

1. Best buy:
High EPS GR companies
Bought at a discount
Held for long haul

2. Good buy:
High EPS GR companies
Bought at a fair price
Held for long haul

3. Good buy:
Low EPS GR companies
Bought at a discount
Held for short haul

5. Do not buy
High EPS GR companies
Bought at high price
Avoid meantime
Be patient

6. Do not buy
Low EPS GR companies
Bought at high price
Avoid



The high CAGR in the early years of the investing period, due to buying at a discount, tended to decline and approach that of the intrinsic EPS GR of the companies over a longer investment time-frame.


http://spreadsheets.google.com/pub?key=thtZJOZYT-iKNP3VPKg9jig&output=html


Chapter 20 - “Margin of Safety” as the Central Concept of Investment
A single quote by Graham on page 516 struck me:

Observation over many years has taught us that the chief losses to investors come from the purchase of low-quality securities at times of favorable business conditions.

Basically, Graham is saying that most stock investors lose money because they invest in companies that seem good at a particular point in time, but are lacking the fundamentals of a long-lasting stable company.

This seems obvious on the surface, but it’s actually a great argument for thinking more carefully about your individual stock investments. If most of your losses come from buying companies that seem healthy but really aren’t, isn’t that a profound argument for carefully studying any company you might invest in?

PE ratio, PEG and EPS Growth rates

A high PE ratio by itself means that either

• the valuation is very expensive (where the stock price is high as compared to its EPS) or
• it has such great potential for growth that investors are willing to accord it with a high PE ratio.

In general, the lower the PE ratio, the better it is.

For high growth stocks, we also look at the PEG ratio (PE ratio/ EPS Growth rate). For high growth stocks, their PE ratio if viewed on absolute basis is usually very high. How do we then decide if it is still "cheap" enough for us to hold or even buy? We use the PEG ratio to see whether its growth is at a faster rate as compared to its appreciation in value (i.e. high PE ratio). If PEG is low despite a high PE ratio, this would indicate the growth in earning (higher EPS growth) is much faster than the increase in its valuation (higher PER), and hence could justify our holding or even buying the stock.