A little logic goes a long way in successful stock picking. It’s easy to get caught up in indicators and share prices and to overlook the most important facts to get right when buying any company.
Purchasing a share involves taking part-ownership in a business. Think of it like buying a stake in the local gym or newsagent. Therefore for goodness sake make sure the company brings in loads of cash, its costs are low, it doesn’t hold too much debt and has plenty of opportunities to expand and squash its competitors.
However it’s wise to get some financial backup before diving into a share purchase so we’ve put together a couple of financial items to check out before hitting the buy button.
Earnings & dividends
First up, if you’re looking for a stock that won’t blow up your cash (and aren’t we all) then check out its consistency in paying dividends. If a company has a history of paying out roughly the same amount to shareholders each year, it’s fair to say that its earnings (profits) are pretty stable and predictable – and this is exactly what you’re looking for in a company. Go back five years or longer and see what you find.
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Next up, take a look at its earnings history. What you’re ideally looking for is a company that has displayed a history of increasing earnings over many years. If you plotted the earnings on a chart, it would be rising over the years and the steeper the incline the better.
Clearly, there will be some down years, often corresponding to a downturn in the business cycle – particularly if the company’s revenue stream is not diversified across different markets. This isn’t so bad provided the company makes up for it in good times.
Check out the company’s projected earnings. The future bodes well for a company with strong forecasted earnings, whereas a company that keeps slashing its earnings forecasts might be best avoided (at least for the time being).
Many listed companies keep the market up to date by announcing what’s commonly termed “earnings guidance.” It’s a company’s way of communicating its expectations to the market – or specifically, how sales and earnings are shaping up in light of business conditions.
This information is crucial for investors to mull over, but always be aware that management may ‘happen’ to over-estimate or under-estimate earnings forecasts to influence the market. Overly ambitious forecasts may be employed to boost an ailing share price, while a less generous forecast can be used to surprise the market “on the upside” come reporting season, which is always handy for the stock price.
Company analysts at stockbrokers employ rigorous financial models in their attempt to gauge a company’s future earnings. (Financial models are basically big excel spreadsheets with a company’s financial data keyed in alongside the analyst’s own projections for industry and macro growth rates, currencies, sales growth, interest on loans and so forth).
A company analyst will arrive at their own forecasted earnings figure, and use this forecast to value the stock. Once the valuation is in place, the analyst writes a report alongside a recommendation to Buy, Sell or Hold.
Some of you might have heard of the term “consensus forecasts.” This figure is the average, or median, of all forecasts from individual company analysts that cover a particular stock. Understandably, consensus earnings figures for big cap stocks such as BHP Billiton and Telstra will be made up of more individual analysts’ forecasts than small stocks, which may attract just two or three analysts in the country.
Fund managers often rely on consensus forecasts as they push millions of dollars through the markets – buying and selling shares for scores of unitholders. With this in mind, it’s probably worthwhile keeping up to date with the consensus forecasts of the stocks on your watchlist.
It’s true that stocks are often measured by whether they can beat a consensus earnings estimate come reporting season. Companies that fail to meet consensus forecasts often get pummelled by the market; while those that meet, or better, beat consensus earnings can be rewarded by a price spike. Indeed, with so many investors keeping tabs on consensus earnings, the difference between actual and consensus numbers can be a big driver of share price performance.
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