Finding the Next Google
Judging from my mail, most investors are
looking for the next Google. That is, stocks with rapidly growing
earnings that will send their share prices through the roof. With that
in mind, here are six rules to keep in mind when you are evaluating
You can find most of the needed information
on Yahoo’s (finance.yahoo.com)
Statistics report and/or on Reuters’ (www.investor.reuters.com)
Ratios report. In both cases, find the report by entering the ticker
symbol to get a price quote, and then selecting the desired report.
You’ll also need to access analysts’ revenue forecasts, which can be
found on Yahoo’s
Estimates report, which is listed on the same menu as its Key
Not Too Cheap
It’s easy to understand why cheap stocks, say those trading below $5 per
share, are tempting. After all, you could turn $100 into $10,000 if you
bought 100 shares of a $1 stock that eventually went to $100.
Unfortunately, cheap stocks trade that way
because most investors see long-term fundamental problems. In my
experience, they are usually right. Buying cheap stocks adds unnecessary
risk. Avoid stocks trading below $5 per share.
A stock is said to be in an “uptrend” when its share price is, despite
occasional dips, generally moving up over time. It’s in a “downtrend”
when it’s heading the other way. Checking the price trend is important.
Often, a stock drops because in-the-know
players hear bad news before the company tells the public. Same thing
with good news. An uptrending price chart is often your first clue that
good news is on the way.
You can tell whether a stock is in a
long-term uptrend by comparing its recent price to its 200-day moving
average (average close over the past 200 market days). Uptrending stocks
are trading above their moving averages and downtrending stocks are
trading below. The distance between the share price and the moving
average reflects the strength of the trend. For example, stocks trading
at least 20% above the moving averages (e.g. share price is $120 and MA
is $100) are in strong uptrends. On the other hand, stocks trading at
double their moving averages have probably gone up too far—too fast, and
are risky bets.
Yahoo’s Key Statistics report lists the
200-day moving average. Avoid stocks trading at less than 10% above
their 200-day moving averages, or that are trading at more than double
their 200-day MAs.
Historical Sales Growth
Rising earnings usually drive share prices higher. But, investors
sometimes lose sight of the fact that, long-term, earnings growth comes
from revenue (sales) growth. The best growth candidates have already
recorded strong revenue growth and are expected to maintain, or better,
exceed, their historical revenue growth in coming quarters. Usually,
growth investors look for at least 15% annual (year-over-year) revenue
growth and higher is better.
You can find the historical revenue growth
figures on the Reuters’ Ratio report. Look for at least 15%
year-over-year sales growth for the last 12-months (TTM) as well as for
the most recent quarter (MRQ). In the best case, the most recent
quarter’s growth would exceed the last-12 month figure.
Future Sales Growth
Yahoo’s Analysts Estimates report shows analysts’ revenue growth
forecasts for the current and next quarters, and for the current and
next fiscal years. Look for forecast growth rates at least more or less
even with historical figures, and the best candidates will show
accelerating growth expectations. Avoid stocks with expected revenue
growth significantly below historical levels.
The best growth candidates are highly profitable firms, which
requires more than reporting positive earnings. For example, say that
two firms both reported $10 million in earnings last year. But Company
A’s shareholders had to invest $100 million to generate that profit
while Company B produced the same profit with only $50 million invested.
Thus, Company B was twice as profitable per invested dollar than Company
Profitability ratios such as return on
equity compare a firm’s net income to various measures of shareholders’
investment. My favorite valuation ratio, return on assets (ROA),
compares net income to total assets. ROA values run from negative
numbers for unprofitable firms to as high as 40%. Most firms are in the
5% to 10% range. Find ROA under “Management
Effectiveness” on Yahoo’s Key Statistics report or on Reuters’ Ratio
Look for firms with at least 10% ROA and
higher is better.
Not Too Expensive
Stocks that meet the requirements that I’ve already described usually
attract attention. Eventually, everybody piles on and the stocks get too
expensive. The price/earnings (P/E) ratio, which is the recent share
price divided by the last 12-months earnings, is the most widely
followed valuation gauge. However, earnings can vary substantially from
quarter to quarter. Sales, although hopefully growing, aren’t as
volatile. Thus, the price to sales (P/S) ratio, which is the recent
share price divided by 12-months’ sales, is a steadier valuation gauge
You can find the P/S ratios under Valuation
on both the Yahoo Statistics and Reuters’ Ratio reports. Look for P/S
ratios below 8 for firms with up to 30% expected year-over-year sales
growth, and up to 10 for faster growers.
These tests are intended as a
quick check to rule out bad ideas. Avoid stocks that flunk any one test.
However, that doesn’t mean you should buy passing stocks. Do your due
diligence. The more you know about your stocks, the better your results.