It is often debated whether a commonly perceived “good” company, as defined by characteristics such as competitive advantage, above-average management, and market leadership, is also a good company in which to invest. While these characteristics of a good company can point toward a good investment, this article will explain how to also evaluate the company’s financial characteristics to make a final decision.
While the short-term process may have changed, the characteristics of a good company in which to buy stock have not. Earnings, return on equity (ROE), and their relative value compared with those of other companies are timeless indicators of which companies might be good investments.
What Are Earnings?
Earnings are essential for a stock to be considered a good investment. Without earnings, it is difficult to evaluate what a company is worth, except for its book value. While current earnings may have been overlooked during eras like the internet stock boom, investors, whether they knew it or not, were buying stocks in companies that they expected to have earnings in the future.
Earnings can be evaluated in any number of ways, but three of the most prominent metrics are growth, stability, and quality.
Earnings growth is usually described as a percentage, in periods like year-over-year, quarter-over-quarter, and month-over-month. The basic premise of earnings growth is that the current reported earnings should exceed the previous reported earnings. While some may say that this is backward-looking, and that future earnings are more important, this metric establishes a pattern that can be charted and tells a lot about the company’s historic ability to increase earnings.
While the pattern of growth is important, like all other valuation tools, the relative relationship of the growth rate matters, as well. For example, if a company’s long-term earnings growth rate is 5% and the overall market averages 7%, the company’s number is not that impressive.
On the flip side, an earnings growth rate of 7% when the market averages 5% establishes a pattern of increasing earnings faster than the market. This measure on its own is only a start, though. The company should then be compared to its industry and sector peers.
Earnings stability is a measure of how consistently those earnings have been generated over time. Stable earnings growth typically occurs in industries where growth has a more predictable pattern.
Earnings can grow at a rate similar to revenue growth; this is usually referred to as top-line growth and is more obvious to the casual observer. Earnings can also grow because a company is cutting expenses to add to the bottom line. It is important to verify where the stability is coming from when comparing one company to another.
Quality of earnings factors heavily into the evaluation of a company’s status. This process is usually left to a professional analyst, but the casual analyst can take a few steps to determine the quality of a company’s earnings.
For example, if a company is increasing its earnings but has declining revenues and increasing costs, you can be guaranteed that this growth is an accounting anomaly and will, most likely, not last.
What Is Return on Equity?
Return on equity (ROE) measures the ability of a company’s management to turn a profit on the money that its shareholders have entrusted it with.
ROE is calculated as follows:
ROE is the purest form of absolute and relative valuation and can be broken down even further. Like earnings growth, ROE can be compared to the overall market and then to peer groups in sectors and industries. Obviously, in the absence of any earnings, ROE would be negative. To this point, it is also important to examine the company’s historical ROE to evaluate its consistency. Just like earnings, consistent ROE can help establish a pattern that a company can consistently deliver to shareholders.
While all of these characteristics may lead to a sound investment in a good company, none of the metrics used to value a company should be allowed to stand alone. Don’t make the common mistake of overlooking relative comparisons when evaluating whether a company is a good investment.
Researching Company Data
The world of stock picking has evolved. Previously, it was the duty of traditional stock analysts has become an empowered by individuals using the internet; now, stocks are now analyzed by all kinds of people, using all kinds of methods.
In order to compare information across a broad spectrum, data needs to be gathered. Since the majority of information available on the internet is free, the debate is whether to use the free information or subscribe to a premium service. A rule of thumb is the old adage, “You get what you pay for.”
For example, if you are looking to compare earnings quality across a market sector, a free web site would probably provide just the raw data to compare. While this is a good place to start, it might better suit you to pay for a service that will “scrub” the data or point out the accounting anomalies, enabling a clearer comparison.
While there are many ways to determine if a company that is widely regarded as “a good company” is also a good investment, examining earnings and ROE are two of the best ways to draw a conclusion. Earnings growth is important, but its consistency and quality need to be evaluated to establish a pattern. ROE is one of the most basic valuation tools in an analyst’s arsenal but should only be considered the first step in evaluating a company’s ability to return a profit on shareholder’s equity.
Finally, all of this consideration will be in vain if you don’t compare your findings to a relative base. For some companies, a comparison to the overall market is fine, but most should be compared to their own industries and sectors.