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Stock Selection Guide

Monotonous Excellence

VISUAL ANALYSIS OF SALES, EARNINGS, PRETAX PROFIT MARGIN, AND PRICE: SECTION 1 OF THE SSG

 

GENERAL INFORMATION

SALES:

Sales growth, known as the top line in a company's operation, is the most predictable of the statistics that you analyze because very few short-term factors impact it - especially for a company with annual sales over $100 million. The healthiest growth is organic, growth generated by marketing or through research and development (R&D). Marketing brings in new customers for a company, and R&D adds more products or services for the company to sell.

EARNINGS:

Earnings growth is apt to be less predictable than sales growth because it is affected not only by the factors that influence sales growth but also by factors such as increases in energy or raw materials costs. These factors chop away at the profit before they reach the bottom line in a company's operations. Earnings are affected not only by sales and expenses but also by changes in the number of outstanding shares. Distributing more stock can lower the earnings per share. Conversely, buying back shares of stock can raise the earnings per share. These increases and decreases make sense if you remember that earnings per share are calculated by dividing the net profit (what remains after all expenses including taxes are paid) by the number of shares outstanding. Earnings can also grow faster than sales when the income tax rate comes down.

Because of factors like these, the rate of earnings growth can--for a limited period--vary above or below the rate of sales growth. Rarely, however, can a company sustain a rate of earnings growth greater than the rate of sales growth. Ideally, the rates of change in sales, pretax profit, and earnings should move in tandem. If sales, earnings, and pretax profit lines are going in different directions, look for another company. This is not a high quality growth company showing consistent growth.

GUIDELINES FOR JUDGMENT

OUTLIERS:

SALES GROWTH:

EARNINGS GROWTH:

PREFERRED PROCEDURE:

The Preferred Procedure develops an estimate of what future earnings growth can be in a company by looking at sales – not earnings. It is a conservative method and is a reality check for a projection based on historical growth. Historical sales growth tends to be more consistent and stable than historical earnings growth. Remember, earnings are derived from revenues after deducting costs, taxes and preferred dividends.

To calculate earnings five years into the future, do the following:

A novice investor should not be concerned with this procedure until gaining more investing experience.

RULE OF THUMB FOR FUTURE EARNINGS GROWTH:

RULE OF THUMB FOR GROWTH PROJECTION:

BENCHMARKS FOR SALES AND EARNINGS GROWTH:

BENCHMARKS FOR PRETAX PROFIT BARS: You can see trends in the profit margin by looking at changes in the space between the pretax profit and the sales lines.

BENCHMARK FOR PRICE BARS:

ADVANCED BENCHMARKS FOR VISUAL ANALYSIS OF SALES, EARNINGS, AND PRETAX PROFIT MARGIN: FRONT SIDE OF SSG

Chart

SLOPE OF SALES & EARNINGS LINES: Comparison of the slope of the sales and Earnings lines can tell you interesting things about the direction in which a company is headed.

SALES GROWTH AND TAX RATE IMPACT:


Diagram 1

 


Diagram 2

Bad Sign - Profit Margin is likely decreasing or tax rate is increasing.

 

Number of shares has been increasing (dilution) of there is an increase in the tax rate.

EARNINGS GROWTH AND TAX RATE IMPACT:

TAX RATE: Remember, changes in the tax rate are the least likely reasons for dissimilarities in growth rate - especially when the dissimilarities persist for more than a single year. Uncle Sam and his cohorts in the statehouses are not prone to bestowing gifts on industry. Factors such as carryover losses, in which the full tax benefit of a loss could not be claimed in the year of the loss, can distort the otherwise normal role of taxes in the progression from the top to the bottom line.

 


Diagram 3

Probably company has been buying its shares or there is a decrease in the tax rate.

 


Diagram 4

Good Sign - Profit Margin is probably increasing or there is a decrease in the tax rate.

 

Sources:

 


Take Stock, Ellis Traub, 2001
Better Investing Magazine, various articles
Starting and Running a Profitable Investment Club, Thomas E. O'Hara and Kenneth S. Janke, SR., 1998
Investors Toolkit, 3rd and 4th editions, Inve$tWare Corporation
2000 NAIC Congress and Expo, Philadelphia, PA, Cassette Tapes
The Fool.com: Insider and Institutional Holdings