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In the last article in this series on stock research, we learned how to calculate two important financial measures: intrinsic value relative to government bonds, and return on equity. In this next article, we will be taking a closer look at earnings stability and earnings growth.
Researching Earnings per Share
The reason earnings per share is so important to understand is because it is possible to estimate a company's future stock price by using the company's earnings per share annual growth rate. That is to say, if we understand the growth rate of earnings, it is then possible to develop an estimate of the stock's future price per share. In turn, if we understand how many years it will take for a stock's price to reach a projected value, then we can calculate an annual rate of return the stock will provide to investors.
Earnings per Share Example
To see how this works, we are going to use another example. For the past 5 years, let's assume 3M's net income has grown at an annual rate of 7.6%. We can use this growth rate, along with net income, to project 3M's earnings forward for 5 years. In this example, we can use the 3M 2006 earnings per share value of $4.48, and a compound annual growth rate of 7.6% for the next five years. The calculation then becomes: ($4.48 x (1.076)^5 = $6.46. So using this example, we project 3M's earnings per share value to be $6.46 in five years.
Calculating Price per Share
The next step is to look at the historical Price to Earnings (P/E) ratio for 3M. Over the last 5 years, the P/E ratio for 3M has ranged from a low of 15.8 to a high of 34.4. If we take a conservative approach, and use the lower value of 15.8, we can then multiply this value times our projected earnings per share value to develop an estimated stock price for 3M in five years. Continuing with the example, $6.46 x 15.8 = $102.07. So our expected market price for 3M is $110.56.
Projecting Growth Rates
The next step in our research is to project the annual rate of return if we were to invest in 3M today. Let's assume 3M's common stock is selling for around $70 per share. To solve this problem, you need to solve an equation using Excel or a financial calculator. Unfortunately, you're going to need a tool like Excel or OpenOffice Calc to help solve this problem.
The formula you want to solve is this: $70 x (1+X) ^5 = $102.07, determining the value of X. We've already done this calculation for you, and the answer is 7.8%. This means that if we purchase stock in 3M today, we are projecting an annual rate of return on that investment (based on stock price growth) of 7.8%.
In order to determine where we might want to invest our money, we would repeat this exercise for all of the excellent businesses as we defined them back in Stock Research Part I. We would also want to take a look at earnings stability. For example, as part of our research on a company, we would want to know what is causing an increase in earnings per share. Are the economy or good business practices causing this growth? Or are earnings on the rise because of fancy accounting maneuvering?
Using Net Earnings to Gauge Stability
One way to cut through to the stability of earnings question is to look at the net earnings of the company, and the annual compounding rate for that value. Growth in net earnings helps you understand if the company has been repurchasing stock to boost earnings per share growth.
Since earnings per share is determined by dividing net earnings by the number of outstanding shares of stock, a decrease in the denominator (shares of stock outstanding) will result in a higher earnings per share value. If we examine the net earnings values over a number of years, and calculate the compound annual growth in earnings, we can get a better feel for earnings stability and future growth.
Next Up: Stock Research Case Study
This is a good place to stop and review what we've learned so far. In Stock Research Part I, we learned to identify excellent companies with expanding value. In Stock Research Part II, we learned how to calculate intrinsic value relative to government bonds and return on equity.
Finally, in this installment of our series on stock research, we learned how to calculate earnings growth, project a stock's price, and calculate an annual rate of return on the investment. In the final article in this series, we will go through one more stock research example that pulls together all that we've learned.
About the Author - Stock Research Part III
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