Focus on Fundamental Factors to Find Growth Stocks

How do you identify these companies? All too often we hear a guru telling us that there is one most important factor in picking winning stocks—such as price-earnings ratio or price-to-cash-flow ratio. Truth be told, many fundamental variables have a lifespan, perhaps two to three years at most, before they stop working and the edge is gone. Because of this tendency for the game to change, we have found that it is necessary to rank stocks on more than one fundamental variable. We have found that there are six tried-and-true key fundamental factors that drive stellar stock price performance and have stood the test of time.

Positive Earnings Revisions and Positive Earnings Surprises

The first fundamental variable is stocks whose earnings estimates are revised upward by the Wall Street analysts who cover and research these companies. And once an analyst issues upward earnings projection, it is very likely that more are on the way. This is also true about the earnings surprises. This measures how far above or below the overall consensus estimate of Wall Street analysts the actual reported earnings are. We are looking for stocks that exceed what Wall Street believes they can achieve. Oil and energy stocks, for example, have continuously earned far more than the analysts thought they could. Like earnings revisions, earnings surprises tend to persist—that is, once there is a surprise, more tend to follow.

Sales Growth

All you need to do here is to compare the current quarter’s sales increase against the rate of increase from the same quarter for the prior year. Money can be maneuvered around the income statement to massage earnings, but it is very hard to massage top-line revenue. If a company can continually increase sales over long periods of time, then it would seem to point toward that they have a product or service that is very much in demand.

Operating Margin Growth

A company’s operating margin is simply its operating income; profits left after direct costs such as salary and overhead are subtracted then divided by net sales. We then look at whether this percentage margin is contracting or increasing year over year. The operating margin may show a strong but temporary spike for several reasons—if, for instance, it can reduce expenses so each dollar of sales is bringing a bit more to the bottom line. This is nice, but it is not a sustainable source of growth. The other way margins will increase is when a company’s product is in such high demand that it can continue to raise prices for the product or service without an offsetting boost in costs.

Strong Cash Flow

Cash flow is simply the amount of cash actually earned and kept by a corporation after paying all the costs and expenses of doing business, and it is often the single finest measure of corporate financial health. In straightforward accounting terms, free cash equals operating earnings minus the capital expenditures needed to run the business. Companies that frequently pay out more than they bring in are likely to experience hardship at some point. A company can show earnings, then spend all of it and then some on necessary capital expenditures—which are included in expenses on the income statement—and actually end the year with less money than they began with. Companies with free cash flow have the ability to develop the business, develop new products to increase profits, and reward shareholders with dividends, stock buybacks and higher stock prices.

Earnings Growth and Earnings Momentum

A simple measurement finds those companies that earn more money year after year. It is usually measured in terms of earnings per share, which is just the company’s earnings divided by the number of shares they have outstanding. Stocks are ultimately priced on earnings, and the markets place a huge importance on the earnings per share numbers every quarter. Companies that are continually growing earnings per share year over year should get a higher score than those that aren’t. Earnings Momentum is simply measures the percentage increase of earnings year over year. Companies that are accelerating and increasing earnings faster year over year are stronger candidates than those whose earnings are slowing. There are times when this is without doubt one of the most important variables. When the market is in a strong bull run, earnings momentum is one of the biggest driving forces behind stock prices.

Return on Equity

Return on equity is a measure of corporate profitability. It is calculated by dividing the earnings per share by the equity (book value) per share. The higher this number, the more profitable a company is and the higher return management is providing to shareholders. Corporations that are dominant in their industry tend to earn very hefty returns on the equity invested. Return on equity can tell you just how effectively the company is using the cash it generates from the business. A company that has a very high return on the dollars that have been invested is more likely to produce strong free cash flow.

These indicators measure the financial health of a company, how well their products are selling, and whether they are able to maintain and even increase a very high level of profitability. You should focus on all six variables. The amount each variable counts may be changed or tweaked over time, but all six variables need to be considered.