Page 284 - How to Make Money in Stocks Trilogy

162 A WINNING SYSTEM

In a few cases, you might accept one down year in five as long as the follow-
ing year’s earnings move back to new high ground.
It’s possible a company could earn $4.00 a share one year, $5.00 the next,
$6.00 the next, and then $3.00 a share. If the next annual earnings statement
was, say, $4.00 per share versus the prior year’s $3.00, this would not be a
good report despite the 33% increase over the prior year. The only reason it
might seem positive is that the previous year’s earnings ($3.00 a share) were
so depressed that any improvement would look good. The point is, profits
are recovering slowly and are still well below the company’s peak annual
earnings of $6.00 a share.
The consensus among analysts on what earnings will be for the next year
should also be up—the more, the better. But remember: estimates are per-
sonal opinions, and opinions may be wrong (too high or too low). Actual
reported earnings are facts.

Look for a Big Return on Equity

You should also be aware of two other measurements of profitability and
growth: return on equity and cash flow per share.
Return on equity, or ROE, is calculated by dividing net income by share-
holders’ equity. This shows how efficiently a company uses its money,
thereby helping to separate well-managed firms from those that are poorly
managed. Our studies show that nearly all the greatest growth stocks of the
past 50 years had ROEs of at least 17%. (The really superior growth situa-
tions will sport 25% to 50% ROEs.)
To determine cash flow, add back the amount of depreciation the com-
pany shows to reflect the amount of cash that is being generated internally.
Some growth stocks can also show annual cash flow per share that is at least
20% greater than actual earnings per share.

Check the Stability of a Company’s
Three-Year Earnings Record

Through our research, we’ve determined another factor that has proved
important in selecting growth stocks: the stability and consistency of annual
earnings growth over the past three years. Our stability measurement,
which is expressed on a scale of 1 to 99, is calculated differently from most
statistics. The lower the figure, the more stable the past earnings record.
The figures are calculated by plotting quarterly earnings for the past three
or five years and fitting a trend line around the plotted points to determine
the degree of deviation from the basic growth trend.