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    A Growth Investor's Guide to Evaluating Earnings

    by Paul Quinn

    Earnings are the reason corporations exist, and are the single most important determinant of a stock’s price.

    But how do you evaluate a firm’s earnings?

    This article outlines the basics of evaluating earnings from the perspective of an investor who is seeking growth, but at a reasonable price. It provides a step-by-step approach for examining:

    • How much a company earns,
    • How a company’s stock price relates to current and future earnings growth,
    • The linkage between revenue and earnings, and
    • A company’s use of reinvested earnings.

    To illustrate, I will use Landstar System Inc. (LSTR) throughout the article, based on data primarily from the MSN Money Web site (investor.msn.com), an easily accessible and low-cost Internet data source for most individual investors.

       Earnings Per Share: Which Do You Use?

    There are generally two types of earnings per share figures: basic earnings per share and diluted earnings per share. Basic earnings per share is the amount of earnings attributable to each share of common stock outstanding. On the other hand, diluted earnings per share reflects the maximum dilution that would result from conversions and exercises of convertible debt, warrants and options. These rights to the common stock may decrease earnings per share in the future and are a more accurate representation of a company’s capital structure. For this reason, I recommend investors use diluted earnings per share, as has been done in the example.

    Step 1: How Much Does the Company Earn?

    Earnings are a company’s total revenue minus cost of sales, operating expenses, and taxes. The earnings figure is found on the bottom line of a company’s income statement. Earnings divided by the number of common shares outstanding is known as earnings per share. A company’s growth rate is synonymous with its earnings per share growth (earnings growth).

    In the example in Table 1, Landstar System’s consolidated income statement shows net earnings of $119,956 million for 2005. Dividing this figure by the number of shares outstanding provides the earnings per share figure of 1.98 for 2005($119,956 ÷ 60,584 = $1.98).

    Landstar’s earnings per share figure by itself is interesting, but unfortunately does not provide any indication of whether or not this stock is a sound investment. For that, we need to analyze the company’s earnings growth and earnings stability.

    Table 1. Landstar System Inc.: Consolidated Income Statement Highlights
      Fiscal Year
    2005 2004 2003
    (Dollars in thousands, except per share amounts)
    Total Revenue $2,520,523 $2,021,282 $1,597,791
    Cost of Revenue $2,171,036 $1,608,432 $1,222,724
    Gross Profit $349,487 $412,850 $375,067
    Operating income (or Loss) $199,482 $119,419 $84,795
    Net income $119,956 $71,872 $50,700
    Net Earnings $119,956 $71,872 $50,700
    No. of Shares Outstanding $60,584 $61,959 $63,750
    Diluted earnings per share $1.98 $1.16 $0.80

    Earnings Growth
    Companies with strong earnings growth benefit from the current business cycle and market environment. As economic and market conditions change, the resultant set of companies will change as well. Over the last several years, the strong earnings growers were the homebuilders, while more recently the baton has been passed to the oil and gas stocks.

    An investor seeking reasonably priced growth identifies these leading companies by focusing on proven records of earnings growth, over both the short and long run. It is also important to look for companies that are still in a stage of earnings acceleration. Sound companies have a steady and significant record of annual earnings, in addition to a strong record of current earnings.

    Annual earnings growth and stability

    • Increasing annual earnings growth: Look for earnings per share to be higher for each year when compared against the previous year. This helps guard against a recent reversal in trend. Also, look for stocks that exhibit strong longer-term earnings per share growth rates. A 15% growth rate would be a good minimum for investors seeking growth stocks. Landstar’s five-year earnings per share growth rate has been running at almost 26%.

    • Annual earnings stability: In addition to earnings growth, look for companies with persistent, rising earnings on an annual basis. This earnings stability requirement allows you to gauge the overall trend in earnings and the probability of the growth continuing into the future (see Table 2).

    Table 2. Landstar EPS Growth (Year Over Year)
      FY (12/06) FY (12/05)
    1st Qtr 41% 123%
    2nd Qtr na 34%
    3rd Qtr na 71%
    4th Qtr na 77%

    Quarterly earnings growth and acceleration

    • Recent quarterly earnings growth: Next, take a look at the company’s recent quarterly earnings growth. You want to see positive growth in quarterly earnings per share between the most recent fiscal quarter and the same quarter the prior year. A minimum increase in quarterly earnings per share of at least 15% over the same quarterly period one year ago is a good target for growth stocks.

    • Long-term quarterly earnings growth: Next, examine the same-quarter growth in earnings per share going back several quarters (see Table 3). In general, same-quarter growth is a better benchmark than sequential-quarter growth because seasonal patterns are less likely to have an influence. The key here is to avoid stocks with negative or weak growth rates on a same-quarter basis. There are a lot of stocks to choose from so don’t confine your purchases to underperformers. Landstar’s long-term quarterly earnings growth has been strong.

    • Quarterly earnings acceleration: In addition to positive quarterly earnings per share growth, look for acceleration in quarterly earnings per share. Be wary of any stocks with a slowing rate of earnings per share growth two quarters in row. Landstar’s quarterly earnings per share (Table 3) show that the company was on the right track until the most recent quarter.

    Table 3. Landstar Quarterly EPS Results
      FY (12/06) FY (12/05) FY (12/04)
    1st Qtr $0.41 $0.29 $0.13
    2nd Qtr na $0.39 $0.29
    3rd Qtr na $0.60 $0.35
    4th Qtr na $0.71 $0.40
    Total $0.41 $1.99 $1.17

    Step 2: How Does the Price Relate to Earnings?

    While earnings growth is a good start, it unfortunately doesn’t tell you anything about how the market values the stock. For that, you need to understand how price relates to earnings.

    Price Relative to Earnings Growth
    A chart with both price and earnings is the quickest way to see how these two relate (see Figure 1). On chart after chart the two lines will move in tandem. If the stock price moves away from the earnings line, sooner or later it will tend to reflect earnings levels.

    In the case of Landstar, you can see the price has moved up with earnings growth, despite some short-term volatility.

    Price-Earnings Ratio
    The price-earnings ratio (P/E), also known as the earnings multiple, is a widely used analytical tool among investors seeking reasonably priced growth, and for good reason. It tells you what investors are willing to pay for a company’s earnings. The price-earnings ratio is calculated by taking the current price of a stock and dividing it by its earnings per share for the prior 12 months. A typical range for reasonably priced growth stocks would be P/Es of between 15 and 25, depending on the industry.

    In our example, Landstar has a price-earnings ratio of 20.8. This was calculated by taking the current price of the stock ($44.01) and dividing it by the company’s earnings for the prior 12 months ($2.11 per share through the first quarter of 2006): $44.01 ÷ $2.11 = 20.8.

    Another way to look at P/E is to consider how many years it will take an investor to earn back his principal in company earnings—assuming earnings remain constant. With Landstar’s P/E of 20.8, it would theoretically take the company almost 21 years of identical earnings to earn the investor’s principal back.

    Comparable P/Es
    The first step in analyzing price-earnings ratios is to find those stocks whose P/Es are near or slightly above the comparable industry average. In the case of Landstar, the current price-earnings ratio of 20.8 is slightly above the trucking industry’s 20.1 average (see Table 4).

    Figure 1.
    Landstar’s Stock Price
    vs. EPS Over the Last
    5 Years
    CLICK ON IMAGE TO
    SEE FULL SIZE.

    Table 4. Comparing P/Es: Landstar vs. Trucking Industry and Market
      Company Industry S&P 500
    Current Price-Earnings Ratio 20.8 20.1 17.7
    Price-Earnings Ratio 5-Year High 32.7 na 64.8
    Price-Earnings Ratio 5-Year Low 11.0 na 16.4

    High and Low P/Es
    Price-earnings ratios run the gamut from the company selling at a high price because it is the latest story stock on Wall Street, to a company experiencing financial difficulties. Investors looking for reasonably priced growth stocks should avoid both very high and very low P/Es for the following reasons:

    • Low P/Es: In general, there are two types of companies that have very low price-earnings ratios—companies that are experiencing financial difficulties, or those in neglected industries. Although some investors see value in low P/Es, the risks of investing in financially troubled firms usually outweigh the benefits since the risk of these firms going bankrupt is high. Neglected stocks tend to be ignored by the market because of bad news surrounding the company itself or the industry in which it operates. It takes patience to wait for these conditions to change, conditions which are not favorable for investors seeking growth.

    • High P/Es: High P/E stocks are almost invariably expected to show rapid earnings growth and are typically young, fast-growing companies. A company with a high price-earnings ratio will eventually have to meet its growth expectations by substantially increasing its earnings, or its stock price will drop. It is also important to note that in a few cases, a price-earnings ratio may be abnormally high because a company has had a temporary setback and written off some long-term losses against the current short-term earnings.

    P/Es and Accounting Earnings
    As we have seen, the simple price-earnings ratio is a useful measure to quickly find out if any stock is overpriced, fairly priced, or underpriced relative to a company’s money-making potential. This use makes the P/E a valuable tool, but it has its shortcomings.

    The primary drawbacks all have something to do with the denominator in the price-earnings ratio: accounting earnings. Accounting earnings can be influenced by somewhat arbitrary accounting rules that provide a company’s management with flexibility in managing the apparent profitability of the firm. A prominent example of earnings management is the use of historical cost in depreciation and inventory valuation. In times of high inflation, inventory and depreciation costs tend to be understated; the replacement costs of both goods and capital equipment will rise with the general level of prices. Thus, price-earnings ratios tend to be lower during times of high inflation because the market views earnings in these periods as lower quality and artificially distorted by inflation.

       Extraordinary Earnings

    Whenever you are analyzing earnings, the issue of how to handle one-time events comes into play. Extraordinary earnings can distort the actual trend in earnings and make company performance look better or worse than a comparison against a firm without special events. I recommend excluding these non-recurring items and analyze growth in earnings from continuing operations only. This is what is being shown in the example here.

    Step 3: How Does the Price Relate to Future EPS Growth?

    While the price-earnings ratio is a useful tool in analyzing earnings relative to price, it alone does not provide the whole picture of a stock’s real value. For that, you need to understand the PEG ratio, or the price-earnings ratio in relation to a company’s long-run growth prospects.

    The PEG ratio, in various forms, may very well be the most important metric to any investor seeking growth stocks at reasonable prices. The PEG gauges the balance between a stock’s growth potential and its value. The PEG ratio is calculated by dividing the P/E by the company’s projected earnings per share growth rate for the next five years.

    A common rule is that a company’s earnings growth rate should be roughly equal to its price-earnings ratio. In other words, the PEG ratio should be about 1.0 and, in most cases, closer to 0.5. To an investor seeking reasonably priced growth, a PEG below 1.0 indicates that a stock’s price is lower than it should be given its earnings growth and warrants further analysis.

    Landstar has a price-earnings ratio of 20.8 and is estimated (by earnings analysts as reported to MSN Money) to grow its earnings by 13.4% over the next five years. Dividing 20.8 by 13.4% gives us a PEG ratio of 1.55, which is higher than the rule of thumb. Keep in mind, however, that like the other indicators we have explored, a high or low PEG ratio alone is not enough on which to base a decision.

    • High PEGs: High PEG ratios are considered less useful in assessing cyclical stocks, as well as companies in industries like banking, oil or real estate where assets are a more important determinant of value. Landstar is in a cyclical industry—trucking. On the other hand, it is non-asset based company. Either way, it still may warrant additional consideration. You should also assess your confidence in the estimated growth rate.

    • Low PEGs: A very low PEG ratio may reflect high risk. If the PEG ratio has suddenly fallen, you will want to learn more about the company, its financial condition and the industry in which it competes. A company’s growth rate may be exceptionally high for reasons other than the ongoing strength of its business and, therefore, unsustainable. This can be the result of an upgrade of analysts’ earnings forecasts for the company—or a sharp drop in the price of its shares. Depending on your tolerance for risk, either of those developments could still signal a good growth candidate.

    Step 4: How Does Revenue Relate to Earnings Growth?

    Figure 2.
    Landstar’s Revenues vs.
    Earnings: 1996 to 2005
    CLICK ON IMAGE TO
    SEE FULL SIZE.

    Since revenue drives earnings, an investor wants to see them move roughly in tandem. To identify such companies, you should look for positive growth in revenue as compared to the same quarter the prior year.

    One look at the Landstar’s chart (see Figure 2) confirms a positive relationship.

    In general there are two instances where the growth rates will not move in tandem:

    • Earnings > Sales: In a situation where the long-term growth rate in earnings is substantially greater than the growth rate in revenue, this is a red flag to study the sustainable nature of the growth. While it may be possible in the short term for a company to improve earnings through cost cutting, ultimately increases in sales drive long-term earnings growth. However, in the interim, it is possible for a company to increase its earnings at a rate higher than that of revenue due to operating efficiencies and financial leverage.

    • Earnings < Sales: In the situation where earnings growth is lagging sales growth, be careful about immediately drawing negative conclusions without further study. The usual culprit for this imbalance is competition and price cutting, but the expenses required to introduce a new product or service may also serve as an explanation.

    Step 5: How Well Has the Firm Used Reinvested Earnings?

    The final piece of the earnings analysis puzzle is return on equity.

    Return on equity is a measure of how well a company used reinvested earnings to generate additional earnings. It is equal to a fiscal year’s aftertax income (after preferred stock dividends but before common stock dividends) divided by book value (which is equal to its assets minus its liabilities), expressed as a percentage.

    Figure 3.
    Landstar’s Return on
    Equity: 1996 to current
    CLICK ON IMAGE TO
    SEE FULL SIZE.

    An investor seeking reasonably priced growth typically likes to see a high and increasing return on equity. One year’s return on equity means little, but by analyzing several years’ results for the company and its industry, you can spot trends and get an idea of how well the company manages its assets (see Figure 3).

    In the case of Landstar, its current return on equity is a very high 46.2, as compared to the trucking industry at 14.5. The long-term trend has been strong although decreasing until recently.

    Summary

    If you are a growth stock investor seeking reasonably priced stocks, this should provide you with a starting point for analyzing earnings.

    In the case of Landstar, overall it checks the majority of the earnings criteria boxes. It has healthy growth prospects and reasonably priced shares. The areas to be vigilant of going forward:

    • Quarterly earnings deceleration from last quarter 2005 to first quarter 2006.
    • The PEG ratio of 1.55 is higher than the rule of thumb of 1.0.

    But Landstar is just an illustration. If you choose to incorporate this strategy, it is important to perform due diligence to verify each company’s financial strength and earnings potential.

→ Paul Quinn