Harry Domash's Winning Investing


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 growth candidates.

You can find most of the needed information on Yahoo’s (finance.yahoo.com) Key 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 Analyst Estimates report, which is listed on the same menu as its Key Statistics report.

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.

Uptrending Chart
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 A.

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 report.

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.
published 10/28/07


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