You never want to invest in any stock that does not have this component. It is absolutely the number 1 thing to look for when investing. Buffett himself considers this component essential to his investing strategy. So, what is number 3 on our list of the 10 Things To Look For When Buying A Stock?
The answer is earnings, earnings, earnings. A lot of factors may impact a stock’s market price but nothing has the effect on a stock’s price like earnings. Wall Street firms, mutual fund companies, and ordinary investors are all looking for the next great growth story. Stocks with earnings growth have absolutely no problem attracting money from potential investors. Companies like Apple (AAPL), Amazon (AMZN), and Netflix (NFLX) are the darlings of Wall Street because of their strong earnings.
It doesn’t matter what a company’s management says, the earnings report tells the story. Companies can inflate net income by cutting expenses but they can not fake top line revenue growth. If a company’s revenue is dropping, the demand for the company’s products may be falling. Dell (DELL) is a perfect example where the company has seen revenues dip for three straight years.
So, how can you measure a company’s earnings? Start with the income statement. Earnings in their simplest form are revenue minus expenses. Look for companies that have been able to increase revenue and net income for at least five consecutive years. Five to ten years of net income growth shows earnings stability. One bad year of earnings over a 5 to 10 year history is likely an outlier whereas 3 or 4 bad earnings years demonstrate a trend. Quarterly earnings and annual reports are a great way to gauge a company’s earnings progress.
Next, take a look at a company’s earnings per share (EPS). Earnings per share is your share of a company’;s profit. Every share that you own is equivalent to that share of the company’s profits. Find company’s that are growing earnings above the industry average. For example, Apple has done an excellent job of crushing industry averages. Conversely, Dell has failed to meet the industry average. The company is projected to grow earnings at a 7% clip over the next five years whereas the industry average is twice that at 14%.
The key to investing is to try to find great growth stories early. These are the companies that Peter Lynch referred to as multibaggers. Companies that have the potential to see their earnings double or triple over the next few years. If you can find these companies early, you will be smiling all the way to the bank.
Would you ever invest in a company with negative earnings?
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