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Income Statement Analysis
- Great companies and good
EPS growth
do not guarantee
stock market profits
- The P/E ratio can create
buying opportunities
- Mishaps can create steals
- Unusual charges reduce the
value of your stock
- ROE is the single best tool
for investors
- ROA is another valuable tool
- Investors pay for high profit
margins
- Lenders can eat up all the
profits
- Depreciation creates
deferred taxes, which have
equity-like qualities
- EPS is a complicated
calculation
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Great companies and good EPS
growth
do not guarantee stock market profits
Over time, a close
link has developed between earnings growth and stock price appreciation. As
a result, EPS growth is generally the main factor used when determining the
earnings multiple used to pay for a stock. Investors normally pay a premium
for growth companies. Normally, the faster EPS grows, the higher the P/E
ratio. Growth, however, is not the only consideration that determines share
price.
Investors need to
focus on:
The right company
at the right price
at the right market conditions
In the stock
strategies section, the
characteristics of growth investing as a strategy was discussed at length.
Under fundamental analysis, the main concern is the premium paid for growth.
Overpaying for growth can, and often does, result in “dead money” or worse,
loss of principal. EPS growth can make investments extremely profitable, but
only if shares are purchased at a reasonable price and sold when they become
significantly overvalued.
In the 1960’s, there
were the Nifty 50; these were the one-decision buy and hold stocks. Many
fizzled and burned. Xerox, Burroughs, Polaroid and Eastman Kodak were great
investments in their heyday.
Today, we also have
great companies; some are survivors of the Nifty 50. While many performed
excellently over the past decade, their stock prices have declined or have
not substantially increased, including Coca-Cola, GE, Cisco, Medtronic,
Procter & Gamble, to name a few. They are some of the best managed companies
in the world and yet investors have lost money on them in recent years. The
lesson is: great companies and good EPS growth, by itself do not guarantee
market profits.
The “PEG” multiple is
used as a valuation gauge when dealing with EPS growth; it compares a
company’s P/E ratio to its growth rate. The higher the PEG multiple, the
more expensive the stock. A PEG ratio of one normally means fair value. Fair
value, however, is Wall Street’s terminology for overpaying. Value investors
typically focus on situations where the PEG ratio is under one, while
momentum players look at higher multiples. Picking profitable investments,
moreover, is beyond the scope of the PEG ratio. Investors should be looking
for a company whose actual growth rate exceeds expectations. They can then
get a two-fold benefit: first, from the higher EPS and secondly from a P/E
multiple expansion.
Individuals, who
unfortunately, overpaid for a security, have a few choices:
1.
For those longer-term investors who selected a good quality growth
company, time can cure your mistake if you slightly overpaid for the stock.
2.
For those investors who grossly overpaid for a stock, even time can’t
cure the situation. If you find yourself owning a bad investment, sell and
move on. Many of the internet investors who purchased companies like Aether
at its high of $345 per share will never recovery their investment. The same
held true for Burroughs in 1969. If you purchased the shares at its high of
$125 you never recovered your investment, even adjusting for their three for
one stock split.
For investors with a
short-term growth horizon, EPS growth needs to match, or exceed, analyst
earnings estimates. Failing to meet Wall Street estimates, despite excellent
period-to-period growth, can devastate a stock. Additionally, the price can
“flatline,” until street confidence returns.
The stock
price paid, combined with market conditions, dividends, and EPS growth, are
the keys in determining the profitability of an investment. Earning growth,
by itself, does not guarantee profits.
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