Stock Selection Criteria For A High Growth Portfolio - Part 1
By
Jeremy Gard
The first signpost we are going to look at is Earnings, or in other words a company's profitability. Earnings Per Share, or EPS, is generally considered to be the single most important factor in determining a company's share price. What we are looking at here is how much is the company paying us, as the investor, out of the profits that the company has earned. The earnings of the company are a measure of how well the company has performed in its particular industry, and financial analysts around the world are all looking at this number as an indicator on how well the company is likely to do in the future. These analysts will make estimates to the market ahead of the actual announcement by the company about possible future earnings, based on information at hand of that particular industry, and guidance from the company itself. Then when the company actually reports its earnings to "the market" - usually bi-annually, or sometimes quarterly - the market will react based on whether the actual earnings were in-line or out-of-line with the estimates. For example, if analysts suggest that XYZ's estimated earnings for the next period will be $1.00 per share, and the company comes out and announces that it will be paying $1.50 per share, exceeding analysts expectations, then this is seen as an indication that the market is currently under-valuing this company, and its share price will rise swiftly, as investors perceive they are getting a bargain at the current price. The reverse reaction is usually what happens when the actual announcement is less than the estimates, i.e. the price will fall as it's seen now as the company is over-valued. Keep in mind, however, earnings alone are not enough for us to determine if the company is a good buy for our high growth portfolio at this time. It must always be considered with other factors and indicators that the company produces. So how is the Earnings Per Share calculated? Simple enough - it's the company's net earnings, divided by the number of shares outstanding. Net Profit (Earnings) / Outstanding Shares Let's look at a real example, on one of my favourite Aussie stocks - JB Hi Fi (JBH). * The net income (or net profit of the company) for the period up
to June 2010, was $118.7 million. Therefore, the earnings per share = $1.09 (118.7/108.3) Comparing this EPS to the share price at the time gives us the Price/Earnings Ratio, which is also a very important and widely used indicator of company performance. Another way to look at this figure in real terms, is that if you buy shares in this company for $19.00 (approximate current price of JBH), you will earn $1.09 as the return on your investment. In other words, you have given the company your $19.00 to use in their operations, and they pay you $1.09 per year that they get to use your money. It will take approximately 17.4 years for your investment to be returned to you (a PE Ratio of 17.4). I always try to look at my investments in this way as it really puts it into perspective. It also allows me to ask the very valid question: is my money better off somewhere else? Over the next 17 years, can I earn a better return elsewhere? So, the point of all this is for us to determine the long term growth prospects of the company, not just the income. We want share price, growth, not necessarily dividend income. Ideally we want both, but growth comes first. With the EPS figure, we can now look at how this figure has changed over the past years. This will give us an indication of how the management of the company are managing our invested dollars. i.e. is the company growing its profits or just keeping up with its expenses. There are three ways a company can grow its EPS figure, and therefore its profit: 1. Grow the revenues (sell more stuff, or raise the prices of
goods and services) The same as it is for individuals to increase their cashflow, you either earn more money, or reduce your expenses. Company managers that can effectively manage both of the first two points are considered good money managers, and will attract investors funds. The third point is basically where the company is buying back its own shares to reduce the pool of shares in the marketplace. I don't place too much emphasis on this point, as it seems to me that a management team that can't think of new ways to grow their (my) company are usually the ones that opt to just use profits to buy back shares. We ideally want to see growth in the company first, and not have to use valuable profits to reduce the share-holder base. Not important right now though. So, to see how this company has performed, and whether or not we are going to consider it for our high growth portfolio, we look at the historical EPS figures. Using JBH as the example again, we see the following going back 5 years: 2005: 19.8 cents So, clearly the earnings have been growing steadily in this company. Average out the growth rates we get 41.3% over the past 5 years. Clearly this company has excelled in increasing its earnings over past 5 years, and has demonstrated a good ability to grow its earnings for its investors. In our analysis we would give this stock a big tick on this indicator. In the next article, we'll look at the next signpost for our stock selection - Revenue Per Share, or how much money is the company bringing in the door.
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