Analyzing the stock market, in order to find investment opportunities is a daunting task. The goal is to find stocks that will be worth more after a certain time frame, than they are today. There are a lot of metrics that one looks at to do that. However, the main thing that makes the price of a stock go higher is earnings growth. If you identify stocks that will grow future earnings, you will be able to conquer the stock market.
Let me be clear, you need to find stocks that will grow earnings. Amazon is a great company, that has been a consistent earnings grower over time. But who’s to say that it will keep on doing so. Plus, because it has been a consistent earnings grower, Amazon stock’s P/E is a lot higher than the rest of the market. We want stocks that have low a P/E, but will grow earnings. People call this growth at a reasonable price, or GARP.
I like to think of two main factors, when looking for stocks that have a low relative valuation, with the potential for high future growth. Those are the tangibles and intangibles.
Intangibles that indicate if a stock will grow earnings have to do with whether the underlying company is developing a competitive advantage over it’s competitors. If so, is it developing the advantage in an area that is in demand.
The industry that the company is in does not necessarily have to be in growth mode. There can be subsectors, within that industry, which are growing. If the company has identified those areas, invested in them accordingly and proven it can execute, it may be poised for future growth.
You should listen to or read the transcript from the earnings report. Does management sound upbeat about the future? Do they seem like they are aggressively taking business away from their competitors? Is their product line better?
Most of the tangible factors that determine if a stock is a future growth candidate, can be gleaned from the stock’s financial statements. These include the balance sheet, income statement and cash flow statement.
The primary driver of earnings growth is what a stocks return on equity is or it’s ROE. ROE tells us how profitable a company is. It is calculated by dividing a companies income by shareholder equity. A high ROE indicates a company is generating more earnings for the amount of equity invested.
Shareholder’s equity is calculated by taking assets minus liabilities. Therefore, a company with a high ROE is utilizing it’s assets, to generate more growth to it’s shareholders.
You should also look at top line growth, or revenue. This number is harder to manipulate than the bottom line earnings. Also, pay attention to deferred revenue, if a company reports it. A rise in deferred revenue or ratios such as the book to bill ratio, can be an indicator of future growth.
Make sure you look at the amount of debt a company is taking on. If a company is over levered, it may restrict it’s ability to operate and take advantage of potential growth opportunities. However, if a company has a lot of cash, it may have more flexibility, if it does need to take on debt.
Look at a company’s cash flow. Companies that generate a lot of cash, tend to have the ability to grow.
The most widely used ratio, the Price To Earnings ratio or P/E, can be used to judge relative valuation. A stock with high growth, will have a high P/E. So, a stock with a low P/E, that will grow earnings, may be mispriced. As it becomes more apparent that the stock is mispriced, the P/E will rise, as a result of the price rising. This is called multiple expansion.
Keep in mind all these things do not exist in a vacuum. You should use tangible and intangible factors, in tandem, to determine whether a stock is a candidate for future earnings growth.
You can use a tangible to invalidate an intangible. If you determine that a stock has a competitive advantage over it’s competitors, but it’s ROE is low, you may want to take a pass.
You could also use a tangible to pick one stock over another one, in the same industry. If two companies are competing against each other and both are executing, but one has a higher cash flow, it’s stock may do better in the future.
The most important thing, is to dig deep. Pour over companies 10Qs and 10ks. Pay attention to what is going in the market, in different industries and at different companies. Listen to or read the transcripts of the earnings calls. Be patient and when you see something worth buying, go for it.