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More Thoughts on How to Analyze a Stock’s Growth

If you listened to Andrew and Dave’s recent episode dividend growth investing, or maybe your even read my post that talked a little bit more about investing in a growth stock and felt like you were craving a little bit more, I have good news – we have more for you! 

Andrew and Dave recorded a ‘Part 2’ for this episode that continued to dive further into the topic of analyzing a stock’s growth. 

As a recap, Part 1 really focused on the following topics:

  1. Evaluate growth on a term that is longer than a couple years.
    • Things can change drastically in such a short period, so you need to broaden your timeframe to a 7-10-year window to help increase your conservatism when evaluating a company
  2. Compare companies against one another and against the market as a whole
    • If you’re simply comparing a company over the last 7-10 years and that company is up 5%, you might be ecstatic about that, but maybe that company’s peers performed at 8% while the S&P 500 was at 10%?  Looking at only that fact might tell me that maybe the industry is lagging behind and that company is even lagging behind its own peers.  Context is key so don’t evaluate in a vacuum.
  3. Focus on Earnings Growth, Revenue Growth and Dividend Growth
    • These three factors, in my eyes, are king when evaluating a growth stock and are a great place to begin your analysis.
  4. Small-cap companies inherently carry more risk but also more upside
    • The smaller the company, the more volatile that it typically will be, which can mean good or bad things depending on your own investing timeframe.  Understand what you’re looking for and the amount of risk you can handle and then choose your investments accordingly.

So, now that you’ve received your refresher course on part 1, are you ready for part 2?  Let’s get started!

If you’ve ever listened to someone on CNBC talk about ‘growth’ then chances are they are referring to the growth of one ratio and one ratio only – Earnings per share (EPS). 

This is quite simply the amount of total earnings divided by the number of outstanding shares.  In theory, this sounds great because it’s much easier to analyze $5 EPS instead of saying that income is now at $50,000,000 for the quarter.  It’s more relatable and easier to then decipher the P/E, etc. 

But, the issue is that this can be easily manipulated with stock buybacks.  If a company is buying back their own stock then the total outstanding shares will go down, so a company could theoretically make less money the next quarter but increase their EPS. 

It’s not shareholder manipulation, but if you’re not aware, you can definitely be fooled.

Dave brought up a great example of this with GE.  The CEO of GE had this obsession of always beating their earnings every single quarter, even if only by 1 penny! 

The thought process was to continue to show stronger earnings and investors would jump on the bandwagon as the stock price would rise.  Well, the issue for GE is that some people will actually take it upon themselves to dig into the numbers a little bit more, and hopefully you will be that person after this post!

Another example of this that Dave brought up is that a lot of Mergers & Acquisitions (M&A) will instantly increase the book value of a company. 

So, a company could buy up a few other companies quickly and increase their book value and then sell to a different company.  Their book value would look very strong but some of the intrinsic values might no longer be there such as the culture of the company, quality of the workforce if it was hard to retain people and then actually being able to integrate the companies.

If you take away one thing from the Part 1 of this topic and then Part 2, I want it to be that you need to look at more than one thing.  I constantly talk about all of these topics simply being an introduction to things that are part of your investing toolbelt. 

You can’t build a house with just a hammer, so why can you invest for retirement with focusing on only one financial ratio?  Simpler answer – you shouldn’t.

If you’re evaluating a stock (hopefully over the 7-10-year period that we recommended!) and you’re noticing a disconnect between the EPS and the Net Earnings, then dive into it more!  It likely is because the company has bought back some shares at some point. 

More often than not, I think that’s a good thing, but take a look and try to find out why they were buying the shares back and if the stock price was undervalued at that time.  If the company was buying those shares back only because they didn’t know what else to do, then that’s a red flag to me.  That means that they’re not necessarily complacent but that they’re not staying ahead of competition as they should be. 

The status quo makes them a sitting duck for competitors to come into the market.  If they’re buying back shares, I want it to be because they think that the stock is undervalued and that they can increase shareholder value by doing so.

So, I’m challenging you now, go out and make your own checklist of things that are important to you.  Maybe it includes items such as EPS growth, revenue growth, dividend growth, shareholder equity, book value, anything! 

You need to find what is important to you and make your own checklist.  Maybe you only want really risky small-cap stocks, which would mean that they probably don’t have a dividend, so dividends wouldn’t necessarily be as important to you as they would be for someone that intends to live off those dividend payments. 

Personally, I don’t agree with this theory, but guess what – that doesn’t matter! 

I’m not investing in your retirement, and neither is Andrew or Dave – only you are! 

We’re going to tell you what is best for us, you have to decide what is best for you.

If you’re reading this with a “deer in the headlights” type of feeling then I urge you to go take a look an income statement of the company you work for or a company that you have a fascination for – just something you’re very interested in, especially if you’re not as nerdy as I am and really into understanding the numbers. 

Try to read through it and make sense of some of the numbers.  You will likely be able to develop a feeling for what is important to that company and therefore be able to understand what types of things could be beneficial when evaluating other stocks.

As I mentioned, this is simply another tool in your toolbelt.  Hopefully your toolbelt is getting pretty full at this point!