Examine Earnings Growth
Earnings Per Share (EPS) = Company Net Income / Number of Shares Outstanding
When you are using the number of outstanding shares, use the fully diluted shares instead of outstanding shares)
Here is the calculation to get the EPS growth rate
FV = Future EPS value
PV = Current EPS value
N = Number of years
As an investor, you need to question the reason when the earnings drop. Does the company have a temporary problem or is it going to produce reduced earning s in the company years? You need to read the annual and quarterly reports, listen to the company’s conference calls, you will be able to find the reason for the revenue and earnings decrease. Always look for consistent earnings growth from a company so that you can reasonably predict the future earnings of the company.
How Does the Company Use the Retained Earnings? Do the Retained Earnings Reflect in the Stock Price?
When the management of a company invests earnings back into the business, that investment should yield a higher return because of retained earnings. When the management does a great job using retained earnings, it will increase the earnings of the company and in turn, increase the earnings per share.
Market price does not reflect the true value of the company in the short term. If you are looking at 10 years or more, market price will reflect the true value.
What are the Company’s Owner Earnings for the Past 10 years? Does It Grow Consistently?
“Owner Earnings” are the earnings the owner can keep after the capital expenditure. The formula to calculate the owner earnings
Owner Earnings = Net Income + Depreciation & Amortization – Capital Expenditure
If the owner income trend increases over time, you can project the approximate owner income for the future. The number is not perfect.
What is the Company’s Recent Earning Momentum? Is it Comparable to Its Long Term Growth Rate?
An investor’s portfolio should contain some percentage of large capt stocks. When the market is in a downturn, these established company stocks go down less when compared with small or mid cap stocks. When you are researching established companies to invest in, one of the important tasks is to find out if a company’s earning momentum matches with its long term growth rate. When the company is small, its growth rate may be very high. It grows very fast and reaches mid-cap status. When a company is a large cap, its growth rate may not be as high as small and mid cap growth but there will still be growth. The growth may be through internal expansion like expanding to new parts of the world, introducing new products, or entering new markets. The other part of expansion is through acquisition.
When you are researching a company, you need to find out if the company’s growth rate in recent years matches with its long term growth rate. If the company keeps earning momentum, that is great and the company has passed this checklist item.
Does the Company have any One-Time Event that Recently Increased Earnings?
When you are analyzing a company’s stocks, you need to find out if there were any one-time event that increased the company’s earnings recently. If there are one-time events, you need to remove those earnings from your calculation of historic earnings so you can project the earnings conservatively. One time events could be a sale of asset and a big order from a particular customer.
What is the Company’s “Operating Cash Flow”? Does It Grow at a Constant Rate?
Operating Cash Flow is cash generated from the company’s operations. Cash flow numbers are calculated from net income, depreciation and adjustments to net income, changes in accounts receivable, changes in liabilities, changes in inventories, and changes in other operating activities. Cash Flow should be positive.
How has the Business Performed in Previous Recessions?
All companies need to perform in all business conditions. When the economy is on upswing, all businesses do very well. But you need to identify the company that has done better when the economy is in a state of recession, that company is the real winner.
Does the Company have Client Concentration?
Investors need to analyze the company’s client base. Suppose the business is earning more than 10 percent to 20 percent of the earnings derived from the particular customer, that is a disadvantage.
- The end customer can demand price reductions, which will affect the profit margin of the company because the big customer knows that the company relies on them heavily.
- If the end customer’s business depreciates , your company revenue will also come down which is not a good thing.
- If that customer cancels the contract, there will be a big hit to the company’s earnings.