In Part 5 of the description of my investment process, I talked about how I screened for dividend stocks using the S&P 500 Dividend Aristocrats, Dividend Achievers, and the MSN Stock Screener. In the next couple of posts I will cover the items that I use in my fundamental analysis of stocks, starting with revenue and earnings per share analysis. Keep in mind that this is not a tutorial on how to analyze stocks – there are better resources out there that you can use to learn how to evaluate stocks. This is insight into the things I look at through my whole investment process.
When I start looking at a company, I start by looking at the company’s revenue profile to ensure that it has consistently gone up for a number of years. My criteria for a positive revenue analysis is:
1. An increasing revenue trend line for at least the last 5 years
2. A revenue growth trend line that is steeper than the company’s closest competitor
3. Do I expect that the company has a better than reasonable chance of continuing with the steep revenue trend line in the next five years
If the company cannot meet these requirements, then my analysis usually stops. However, there may be some cyclical stocks that see up and down periods in revenue growth. If this is a consistent pattern, then that is ok. Another thing I keep in mind is that very large companies (i.e. Procter & Gamble, Coca-Cola) can have difficulty growing revenues year after year. I don’t necessarily look for a high revenue growth trend line, only a trend line that is up and growing faster than the competition.
Earnings Per Share
Earnings per share (EPS) is a much tougher thing to decipher for a company. Revenue is revenue and is hard for a company to lie about, other than recognizing sales before product actually ships or something like that. EPS on the other hand can be easily manipulated by a company, and not just in illegal ways. There are a number of very legitimate methods a company can present earnings. During my analysis of earnings, I don’t necessarily concern myself with the exact EPS number, but more importantly the trend line. Just as I do with revenue, I require the following criteria be met:
1. An increasing EPS trend line for at least the last 5 years
2. An EPS trend line that is steeper than the company’s closest competitor
3. Do I expect that the company has a better than reasonable chance of continuing with the steep EPS trend line in the next five years
The last point can be tricky, but a further analysis of items such as ROE later on will help to determine how well management is performing in their ability to earn money for the company. I always keep in the back of mind that earnings can be manipulated. Again, I am looking at the trend.
The next step I take when when analyzing EPS is to estimate what the EPS number will be 5 years out. This is obviously a very tricky thing to do, but it will be important later on when I start to value the stock. I look at the past 10 years of EPS history and earnings estimates from services such as Value Line to determine a number I am comfortable with. My approach is to be very conservative in my number to help build in a safety net if things get bad. This will ultimately give me a buy price for the stock that I believe has some safety built in to it.
In Part 7, I am going to talk about the ratios I look at to analyze a stock.