Previously, we learned how to calculate two important financial measures: intrinsic value relative to a risk-free investment, and return on equity. In this article, we'll be examining both earnings stability and earnings growth.
It's important to understand earnings per share because it's possible to estimate a company's future stock price by using a company's earnings per share in addition to its projected annual growth rate. If we understand these two factors, then it's possible to develop an estimate of the stock's future price per share.
By knowing how many years it will take for a stock's price to reach a projected value, we can calculate an annual rate of return the stock will provide to investors. This is expressed by the following formula:
Future EPS = Earnings per Share x (1 + Growth Rate)Number of Periods
Note: The Growth Rate is typically stated as an annual value; therefore, the Number of Periods would be stated in years
To see how this works, we are going to use another example. For the past five years, 3M's net income has grown at an annual rate of 7.6%. This growth rate, along with knowledge of 3M's net income, can be used to project 3M's earnings over the next five years.
In 2006, 3M's earnings per share were $4.48, with a projected annual growth rate of 7.6% over the next five years. The calculation then becomes: $4.48 x (1.076)5, or $6.46. In this example, 3M's earnings per share value are projected to be $6.46 in five years.
The next step in the process is to look at the historical Price to Earnings (P/E) ratio for 3M. Over the last five years, the P/E ratio for 3M ranged from a low of 15.8 to a high of 34.4. Taking a conservative approach dictates using the lower value of 15.8. This number is then multiplied by the projected earnings per share value to develop an estimated stock price for 3M in five years as demonstrated by the following equation:
Future Stock Price = Price to Earnings Ratio x Projected Earnings per Share
Continuing with the example, we'd have $6.46 x 15.8, or $102.07. So the expected market price for 3M in five years would be $102.07.
The next step 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. The formula we need to solve takes the following form:
Growth Rate = ((Projected Market Price / Current Market Price)(1/Number of Periods)) - 1
Note: Once again, the Growth Rate is typically stated as an annual value; therefore, the Number of Periods would be stated in years
Using the above equation, and solving for our 3M assumptions, we'd have:
= (($102.07 / $70.00)(1/5)) - 1
= (1.458143(1/5)) - 1
= (1.078361) -1
= 0.07831, or 7.8%
Based on the information we've examined, we are projecting an annual rate of return on investment (based on stock price growth) of 7.8%.
This exercise would then be repeated for all of the excellent businesses, as we defined them back in Stock Research Part I. It's also important to understand the company's earnings stability. For example, it's critical 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? This is also referred to as quality of earnings.
One way to examine a company's stability of earnings is to look at the net earnings of the company, and the annual compounding rate for that value. Growth in net earnings tells us 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.
In Stock Research Part I, we learned how to identify excellent companies with expanding value. In Stock Research Part II, we learned how to calculate both intrinsic value relative to a risk-free investment and return on equity.
In this article, 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'll run through a stock research example that pulls together everything that we've learned.
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