Eric Tyson - Investing All-in-One For Dummies

A strong company in a growing industry is a common recipe for success. If you look at the history of stock investing, this point comes up constantly. Investors need to be on the alert for megatrends because they help ensure success.

A megatrend is a major development that has huge implications for much (if not all) of society for a long time to come. Good examples are the advent of the internet and the aging of America. Both of these trends offer significant challenges and opportunities for the economy. Take the internet, for example. Its potential for economic application is still being developed. Millions are flocking to it for many reasons. And census data tells us that senior citizens (over 65) will continue to be a fast-growing segment of the U.S. population during the next 20 years. (Millennials are another huge demographic that investors should be aware of.) Small companies can be the ones poised for the most potential growth.

You have to measure the growth of a company against something to figure out whether its stock is a growth stock. Usually, you compare the growth of a company with growth from other companies in the same industry or with the stock market in general. In practical terms, when you measure the growth of a stock against the stock market, you’re actually comparing it against a generally accepted benchmark, such as the Dow Jones Industrial Average (DJIA) or the Standard & Poor’s 500 (S&P 500).

If a company’s earnings grow 15 percent per year over three years or more, and the industry’s average growth rate over the same time frame is 10 percent, then the stock qualifies as a growth stock. You can easily calculate the earnings growth rate by comparing a company’s earnings in the current year to the preceding year and computing the difference as a percentage. For example, if a company’s earnings (on a per-share basis) were $1 last year and $1.10 this year, then earnings grew by 10 percent. Many analysts also look at a current quarter and compare the earnings to the same quarter from the preceding year to see whether earnings are growing.

A growth stock is called that not only because the company is growing but also because the company is performing well with some consistency. Having a single year where your earnings do well versus the S&P 500’s average doesn’t cut it. Growth must be consistently accomplished.

Companies that have established a strong niche are consistently profitable. Look for a company with one or more of the following characteristics:

A strong brand: Companies such as Coca-Cola and Microsoft come to mind. Yes, other companies out there can make soda or software, but a business needs a lot more than a similar product to topple companies that have established an almost irrevocable identity with the public.

High barriers to entry: United Parcel Service and Federal Express have set up tremendous distribution and delivery networks that competitors can’t easily duplicate. High barriers to entry offer an important edge to companies that are already established. Examples of high barriers include high capital requirements (needing lots of cash to start) or special technology that’s not easily produced or acquired.

Research and development (R&D): Companies such as Pfizer and Merck spend a lot of money researching and developing new pharmaceutical products. This investment becomes a new product with millions of consumers who become loyal purchasers, so the company’s going to grow. You can find out what companies spend on R&D by checking their financial statements and their annual reports (see Chapter 4in Book 3).

When you hear the word fundamentals in the world of stock investing, it refers to the company’s financial condition, operating performance, and related data. When investors (especially value investors) do fundamental analysis, they look at the company’s fundamentals — its balance sheet, income statement, cash flow, and other operational data, along with external factors such as the company’s market position, industry, and economic prospects. Essentially, the fundamentals indicate the company’s financial condition. Chapter 4in Book 3 goes into greater detail about analyzing a company’s financial condition. However, the main numbers you want to look at include the following:

Sales: Are the company’s sales this year surpassing last year’s? As a decent benchmark, you want to see sales at least 10 percent higher than last year. Although it may differ depending on the industry, 10 percent is a reasonable, general yardstick.

Earnings: Are earnings at least 10 percent higher than last year? Earnings should grow at the same rate as sales (or, hopefully, better).

Debt: Is the company’s total debt equal to or lower than the prior year? The death knell of many a company has been excessive debt.

A company’s financial condition has more factors than the preceding list mentions, but these numbers are the most important. Using the 10-percent figure may seem like an oversimplification, but you don’t need to complicate matters unnecessarily. Someone’s computerized financial model may come out to 9.675 percent or maybe 11.07 percent, but keep it simple for now.

The management of a company is crucial to its success. Before you buy stock in a company, you want to know that the company’s management is doing a great job. But how do you do that? If you call up a company and ask, it may not even return your phone call. How do you know whether management is running the company properly? The best way is to check the numbers. The following sections tell you the numbers you need to check. If the company’s management is running the business well, the ultimate result is a rising stock price.

Although you can measure how well management is doing in several ways, you can take a quick snapshot of a management team’s competence by checking the company’s return on equity (ROE). You calculate the ROE simply by dividing earnings by equity. The resulting percentage gives you a good idea whether the company is using its equity (or net assets) efficiently and profitably. Basically, the higher the percentage, the better, but you can consider the ROE solid if the percentage is 10 percent or higher. Keep in mind that not all industries have identical ROEs.

To find out a company’s earnings, check out the company’s income statement. The income statement is a simple financial statement that expresses this equation: sales (or revenue) minus expenses equals net earnings (or net income or net profit). You can see an example of an income statement in Table 2-1. ( Chapter 4in Book 3 gives more details on income statements.)

TABLE 2-1Grobaby, Inc., Income Statement

To find out a company’s equity, check out that company’s balance sheet. (See Chapter 4in Book 3 for more details on balance sheets.) The balance sheet is actually a simple financial statement that illustrates this equation: total assets minus total liabilities equals net equity. For public stock companies, the net assets are called shareholders’ equity or simply equity. Table 2-2shows a balance sheet for Grobaby, Inc.