Sales drives earnings; earnings drives the stock price. That’s what it
comes down to for fundamental investors. You might hear of different
ways to buy and sell stocks, and countless books have touted systems
that promise great returns. But over the long term fundamental analysis
is what works in building wealth.
comes down to studying a company’s financial performance. Broadly,
there are those who look for growth stocks and those who look for value
equities, but the line between value and growth investing is gray: As
Warren Buffett says, value and growth “are joined at the hip.”
investing, as practiced by Buffett and his mentor Benjamin Graham, is a
time-tested method involving fundamental analysis that has served many
investors well. But for the typical person who has a job and family and
who is managing his own portfolio while following Perry’s admonition to
keep it simple, fundamental analysis focused on growth stocks might be
This is because individual investors can
spot a good growth company quickly. BetterInvesting’s Stock Selection
Guide arranges the fundamental data in a way that allows users to see a
company’s growth and management performance as well as the stock’s
investment possibilities in just a few minutes; see the Stock to Study
SSG on pages 29 and 30 for an example. Meanwhile, the work required to
spot a good value stock is a little more complex. But as we’ll discuss
later, value should be a vital consideration as well.The Three Most Important Ideas:
Management, Management, Management
The individual investors who belong to BetterInvesting ask two questions when studying a stock:
• Is this a well-managed company?
• Is its stock reasonably priced?
seek great management because talented, capable executives know how to
ensure their company thrives over the long term amid competitive
battles and periodic downturns. These are the people, in other words,
who are responsible for driving the sales and growth increases that
fuel stock prices.
In assessing management, we don’t know
everything about a company’s day-to-day operations and boardroom
discussions. But as laid out in a methodology promoted by association
co-founder George Nicholson, we do have a lot of the information we
need. A first step in finding a well-managed company is to look at the
history of sales and earnings growth. An important indicator of strong
management is its ability to grow the business in good times and bad.
also seek companies that are growing sales and earnings over the long
term at a rate that’s high relative to their size. Smaller companies
generally should be growing earnings by at least 15 percent a year;
mid-size companies, by 10 percent to 15 percent a year; and large
companies, by at least 7 percent annually.
We want smaller
companies to have higher growth rates partly because they generally are
riskier investments than large companies. The higher growth rate
compensates us for this additional risk, and if we do a good job of
assessing these companies, we’ll see handsome returns. As you’ll see in
this issue in “Repair Shop” and “Watch List,” finding small companies
can be challenging but also quite rewarding.
favor consistent growth over the long term. In the graph on this page,
for example, note the railroad-track-like growth of the company’s sales
and earnings. Consistent performance reassures us about the capability
of management. And although the past is no guarantee of future
performance (as they say in the mutual fund world), history informs our
decisions regarding future growth.
Two other tests help us
assess the company’s management. First, we check the company’s
profitability before taxes and other charges outside of management’s
control. We like to see stable or growing profit margins. The other
ratio is return on equity — how well management is using the equity
invested in the company. Again, stable or growing ROE is preferred.
Comparing the company’s growth rates, profitability and ROE with those
of its peers helps determine whether this is a company built for a long
voyage or is simply benefiting from the rising tide for its industry. Evaluating the Investment Potential
we’ve determined the company in question is likely a high-quality one
worth studying further, we next project sales and earnings growth. As
fundamental investors, we know that in the short term, the market may
not reward the company for its excellence. But over the long term, we
trust that it will. So it’s the long-term projections — five years,
very roughly enough for the company to go through a business cycle — we
We start by forecasting sales growth because we
need this for building our earnings projection. With the caveat that
making long-term predictions can be a humbling experience, we have a
number of data points at our disposal, including:
• The company’s historical growth rate.
• Company statements regarding growth goals.
Street estimates of both short- and long-term growth. Long-term sales
growth estimates can be difficult to find but are sometimes buried in
• The industry’s historical growth rate and estimates of future expansion.
experienced investors might consider such factors as the percentage of
recurring revenues, the value of projects under contract but not yet
completed and historical organic growth and growth by acquisition. For
retailers, they might look at projections for store and square footage
expansion as well as same-store sales growth. But history is a powerful
teacher for beginning and experienced investors alike.
then estimate earnings growth in light of the sales projection. We’ll
consider the company’s history of earnings growth and any goals it has
stated. We can also access analyst reports and analysts’ consensus
estimates, but these forecasts are usually overly optimistic.
past and potential future profit margins and tax rates can help us
understand the path revenues will take to earnings. We also want to
think about what will happen to the firm’s number of common shares
outstanding. For example, if a company regularly buys back shares to
reduce the number of shares outstanding and is expected to continue
this practice, we would expect future earnings to be spread among fewer
When we’re finished, we use the earnings growth rate
to arrive at an estimate of earnings per share five years from now. If
we have forecast growth of 15 percent a year, and the EPS at our
starting point is $1, five years from now EPS will be $2. Two things to
keep in mind regarding projections:
• It’s prudent to be conservative.
firm might have increased earnings 25 percent annually over the past 10
years, but such performance is extremely difficult to maintain. Gravity
will eventually take hold as a company moves from small to mid-size to
• Earnings advances can outpace sales growth for only so
long. Over the long term, they usually settle in at the rate of revenue
growth. If you’re going to project EPS increases that are higher than
sales growth, understand where the additional percentage points are
coming from: Increased margins? Lower taxes? Fewer shares outstanding?Checking Valuation
we’ve predicted the EPS five years from now, we’re ready to answer our
second question: whether the stock is reasonably priced. Investors are
good at discovering high-quality stocks but experience more challenges
in determining the proper price to pay for the stock. Our first step is
to study the stock’s price-earnings ratios over the past several years
and forecast the likely high and low P/Es over the next five years. The
P/E, the stock’s current price divided by a company’s EPS, is how much
the market is willing to pay for $1 of a firm’s earnings; it’s the most
common way to measure how expensive a company’s stock is.
valuations can help us in this process, but P/Es often go through
unpredictable periods of expansion and contraction as industries go in
and out of favor on Wall Street. Another idea to keep in mind is that a
stock can trade at extremely high P/Es for a while but eventually will
drop — severely so when a high-growth company stumbles. P/Es also tend
to contract in times of inflation.
After we have predicted
what the high P/E for a stock will be, we’re ready to estimate a
potential high price for our stock. It’s a matter of simple math: The
high point of EPS — what we forecast the EPS to be five years from now
— is multiplied by the high P/E to come up with a potential high price.
For example, if we predict EPS will be $2 in five years and the high
P/E will be 30, our predicted high price will be $60.
projecting the low P/E, we can multiply it by the expected low EPS to
come up with a potential low price. Since we’ve determined this is a
growth company, we usually can use the most recent 12 months’ EPS as
the low point for earnings. I can use other criteria for projecting a
low, but this is a common method for determining this figure.Return Expectations
that we have the stock’s potential range from low to high, we’re ready
to see whether this stock will provide a suitable return. Our SSG
divides the range into three zones: Buy, Maybe (or Hold) and Sell. The
lowest 25 percent of the range is the Buy zone, and the upper-most 25
percent is the Sell zone.
We include the stock’s dividends —
the cash payments of earnings to shareholders — in our return
calculations. This gives us three ways to achieve a return on a stock:
through dividends, through the market increasing the stock’s price in
concert with the earnings growth and through the stock’s price rising
because the market believes the P/E should be higher.
for our stock holdings to return 15 percent annually on average over
the next five years, or a doubling of return. That’s an aggressive
target, but the idea isn’t to be disappointed if we fail to meet it.
It’s to maintain our focus on seeking high-quality growth stocks.
Achieving returns of, say, 10 percent yearly is pretty commendable.Managing Risk
Investors can manage their risk in picking individual stocks by following some simple rules:
that the company have at least five years of financial history. Younger
firms haven’t developed enough of a track record for assessing
• Study only companies that have proven
they can make money. Someone who invests in a company that has never
reported earnings is speculating, not investing.
• Understand the possible risk and reward of owning a stock.
your portfolio. Even if you’ve done your homework on every holding
using all the information you need to make an informed decision, you’ll
still make mistakes. If you have a good-size basket of stocks, however,
you’ll also have some stocks that perform much better than expected.
investing in high-quality growth stocks and diversifying your
portfolio, two other simple principles can help you build wealth over
the long term. First, reinvest all your dividends and earnings. Second,
invest regularly in both good markets and bad; this is often called
The type of analysis I’ve outlined
provides a lot of the information fundamental investors need to
determine whether a stock is a suitable investment. But not everything.
Reading annual reports, listening to conference calls and viewing
company presentations will help you form a fuller picture of the
In today’s unpredictable, volatile market,
fundamental analysis is even more important than usual. But for an
investor using a simple, straightforward methodology that focuses on
the long term, these are also times of great opportunity.