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Type of Securities Investment Strategies Fundamental Analysis Technical Analysis
Introduction to Fundamental Analysis Income Statement Analysis Balance Sheet Analysis Cash Flow Analysis Shareholders' Equity Analysis Ratios and Definitions


Income Statement Analysis

 - Great companies and good
    EPS growth do not guarantee
    stock market profits

 - The P/E ratio can create
    buying opportunities


 - Mishaps can create steals

 - Unusual charges reduce the
    value of your stock

 - ROE is the single best tool
    for investors

 - ROA is another valuable tool

 - Investors pay for high profit
    margins

 - Lenders can eat up all the
    profits

 - Depreciation creates
    deferred taxes, which have
    equity-like qualities


 - EPS is a complicated
    calculation

 

 


Great companies and good EPS growth
do not guarantee stock market profits

Over time, a close link has developed between earnings growth and stock price appreciation. As a result, EPS growth is generally the main factor used when determining the earnings multiple used to pay for a stock. Investors normally pay a premium for growth companies. Normally, the faster EPS grows, the higher the P/E ratio. Growth, however, is not the only consideration that determines share price.

Investors need to focus on:

The right company

at the right price

at the right market conditions

In the stock strategies section, the characteristics of growth investing as a strategy was discussed at length. Under fundamental analysis, the main concern is the premium paid for growth. Overpaying for growth can, and often does, result in “dead money” or worse, loss of principal. EPS growth can make investments extremely profitable, but only if shares are purchased at a reasonable price and sold when they become significantly overvalued.

In the 1960’s, there were the Nifty 50; these were the one-decision buy and hold stocks. Many fizzled and burned. Xerox, Burroughs, Polaroid and Eastman Kodak were great investments in their heyday. 

Today, we also have great companies; some are survivors of the Nifty 50. While many performed excellently over the past decade, their stock prices have declined or have not substantially increased, including Coca-Cola, GE, Cisco, Medtronic, Procter & Gamble, to name a few. They are some of the best managed companies in the world and yet investors have lost money on them in recent years. The lesson is: great companies and good EPS growth, by itself do not guarantee market profits.

The “PEG” multiple is used as a valuation gauge when dealing with EPS growth; it compares a company’s P/E ratio to its growth rate. The higher the PEG multiple, the more expensive the stock. A PEG ratio of one normally means fair value. Fair value, however, is Wall Street’s terminology for overpaying. Value investors typically focus on situations where the PEG ratio is under one, while momentum players look at higher multiples. Picking profitable investments, moreover, is beyond the scope of the PEG ratio. Investors should be looking for a company whose actual growth rate exceeds expectations. They can then get a two-fold benefit: first, from the higher EPS and secondly from a P/E multiple expansion.

Individuals, who unfortunately, overpaid for a security, have a few choices:

1.       For those longer-term investors who selected a good quality growth company, time can cure your mistake if you slightly overpaid for the stock.

2.       For those investors who grossly overpaid for a stock, even time can’t cure the situation. If you find yourself owning a bad investment, sell and move on. Many of the internet investors who purchased companies like Aether at its high of $345 per share will never recovery their investment. The same held true for Burroughs in 1969. If you purchased the shares at its high of $125 you never recovered your investment, even adjusting for their three for one stock split. 

For investors with a short-term growth horizon, EPS growth needs to match, or exceed, analyst earnings estimates. Failing to meet Wall Street estimates, despite excellent period-to-period growth, can devastate a stock. Additionally, the price can “flatline,” until street confidence returns.  

The stock price paid, combined with market conditions, dividends, and EPS growth, are the keys in determining the profitability of an investment. Earning growth, by itself, does not guarantee profits.

 

 

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