The “Great Eight” Fundamental Variables
Growing companies are companies that are healthy and thriving. They have smart leaders who know how to run and manage a smart business. If a company is struggling to sell its products or is spending more than it makes, it’s not a company that you want to own for growth. And there are eight fundamental variables that are a significant part of my formula when evaluating a company come earnings season. Take a look:
#1 Earnings Growth: Earnings growth is the heart of all good financial analysis. Simply, “earnings” is just another word for “profits.” This is a deceptively simple idea that is too often overlooked. The mainstream media is always finding excuses why a company didn’t post bigger profits—consumer spending was down, a key contract fell through, you name it! But I’m not in the business of making excuses. I’m in the business of finding companies that are posting bigger profits no matter what the rest of Wall Street is doing. As long as any company is vital and able to grow its earnings consistently, its stock will do well.
#2 Sales Growth: This is one of the hardest numbers to fake. Sales are the lifeblood of any business—whether it is selling a service, a gadget, raw materials or anything else under the sun. There are many ways that companies can temporarily find capital, such as selling off assets or making outside investments, but it’s always bad news if people aren’t buying what a business is selling. Great companies make sure that sales increase month to month and year to year so they can expand, dominate their industry and deliver big returns to shareholders.
#3 Earnings Surprises: One key metric I closely examine is whether or not a stock is consistently beating analysts’ estimates. Beating estimates is called an “Earnings Surprise.” I measure these as a percentage, calculated as the difference between actual earnings and consensus estimates. I grade over 5,000 stocks on this key metric, and only stocks with the highest grades are worthy of my recommendation. If a stock beats Wall Street’s earnings forecast by a significant amount, share prices can rally dramatically. This is why I closely monitor the market to find stocks that regularly post earnings surprises. When I find an unsung stock that has regularly performed better than the “experts” have predicted, I recommend it on the premise that it should top expectations again—and see shares surge when it does.
#4 Earnings Momentum: While earnings growth is important, I also want to see a company’s rate of growth increase. This is what I refer to as Earnings Momentum. If a stock has shown that it is making more and more profits every quarter, it’s logical to think more of those profits will be returned to shareholders. But if a business is seeing earnings shrink or dip into the red, I do not consider it to be a good investment.
#5 Cash Flow: Simply, cash flow is the money a company has left over after paying for the costs of its business. This is a crucial indicator of success because brisk sales and revenue don’t always add up to big profits or an ability to expand. If every cent of a company’s cash is tied up paying bills, a big sales number has a limited impact. If a company is flush with capital and on top of its game, it will deliver shareholders big profits!
#6 Analysts Earnings Revisions: Upward revisions are an important indicator of a company’s future success. You see, analysts are paid to estimate a company’s earnings outlook. If an analyst makes a wrong estimate that ends up costing investors money, that analyst could be out of a job. If a number of Wall Street analysts start to move their forecasts higher, it’s a good bet that the stock will outperform expectations and deliver market-beating returns to investors since positive revisions are never made lightly.
#7 Operating Margin Growth: Making profits is all about the margin—the difference between production costs and the retail price. A company that’s able to expand its operating margins is usually a company that has a dominant position in its industry. This company can raise prices without seeing a drop-off in sales. That’s a nice place to be. But if a company has to keep cutting prices to entice reluctant buyers, it’s not a good sign.
#8 Return on Equity: This is one of my gold standards. In simple terms, Return on Equity is the amount of profits a company generates with the money shareholders have invested. ROE tells me how efficiently a company is managing its resources. I can’t interview every senior manager at a company, so I like to think of ROE as a report card for management. To check out a company’s Return on Equity, simply take a business’s net income and divide that by the amount of money shareholders own in common stock. If a company is run well, its net income will dramatically outpace what investors have pumped into it. If a company is lazy or poorly run, the value of shares investors own will be more than the profits the company actually produces.
These eight fundamental variables will help you get to the real facts that will make you money in all markets and at all times. The only way to profit in this market is to take a hard look at the numbers behind the stocks so you can invest in the biggest, strongest companies that will emerge from bear markets stronger than they were before.
But this isn’t all you need to know when it comes to earnings season—there’s plenty of other jargon that you should be familiar with. Let’s take a look.