One problem with only looking at earnings growth estimates for
companies is that they are based on the projections of Wall Street
analysts that tend to be too negative at the bottom of a bear market
and the end of a recession and two rosy towards the end a bull market.
So, you have to be extra careful if you are near the end of a bull
market when it comes to growth stocks. Time and time again once a bear
markets begins and the economy starts to slow down companies fail to
meet optimistic analyst projections and have to guide down their
expectations.
This can really hurt growth stocks because they get valuation premiums
for being growth stocks. The higher that premium gets – the higher the
forward P/E and PEG ratios are – the harder a growth stock can get hit
if it fails to meet analyst projections. In the end, this is not
something you should get worked up over if you keep a close eye on the
overall trend of a stock and use proper stop loss orders to protect
yourself if a stock gets hit by bad news or the stock market enters a
bear market.
What is more, companies have been known to play accounting games to
create earnings growth. But there are some red flags you can watch for
in order to know if this might be happening. The simplest is looking
at the sales figures for a company. If earnings are growing but sales
are flat or even falling, the company is probably boosting earnings
through temporary measures such as cost cutting, the acquisition of a
competitor, and accounting changes. This type of thing can lead to
problems later with the growth story of a company.
It is best to buy growth companies that display a pattern of
consistent sales growth. Ideally, you want to see several years of
earnings growth of 25% and consistent growth. You do not want to see
growth of 10% one year, then 25%, and then back down to 5% the
following year. That means the growth may not be sustainable. If the
company has been around for some time, it is best to see five years of
earnings growth of at least 25% a year and the higher that number the
better.
If you are doing short-term trading with a time frame of holding for
several weeks, you do not need to worry about these things too much.
But if you are investing in stocks to hold for the long- term, then it
is best to make sure you are only buying quality companies. Some other
metrics you can look at (to make sure this is the case) are the return
on equity ratio and the current ratio.
The return on equity ratio is calculated by dividing the net income
after tax the company generates by shareholder equity which is the
ownership shareholders have in assets. There can be a negative equity
if the company has more liabilities than assets. The return on equity
tells you how well a company uses it investment funds to create
earnings growth. It gives you an idea of how well the company
reinvests its earnings. The best companies have a return on equity
over 20%.
On the flip side, you do not want to invest in companies with huge
debt loads that might send them into bankruptcy. You can use the
current ratio (which divides the current assets by liabilities) to
make sure you are investing in companies with solid balance sheets.
Companies that have twice as many assets as short-term debt tend to
make the best investments but this ratio is normally bigger with real
estate and financial firms.
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