It is often debated whether a commonly perceived "good" company, as defined by characteristics, such as competitive advantage, above-average management and market leadership, is also a good company to invest in. While these characteristics of a good company can point toward a good investment, this article will explain how to evaluate the company's financial characteristics to make a final decision.
Background
The world of stock picking has evolved. What was once the duty of traditional stock analysts has become an internet phenomenon: stocks are now analyzed by all kinds of people using all kinds of methods. Furthermore, the speed at which information now travels around the world has led to increased volatility in stock prices and changes in the way that stocks are evaluated, at least in the short-term.
In addition, the advent of self-directed 401(k)s, IRAs and investment accounts has empowered individual investors to get more involved in the selection of stocks to buy.
But while the short-term process may have changed, the characteristics of a good company to buy stock in have not. Earnings, return on equity and their relative value compared to other companies are timeless indicators of companies that might be good investments.
Earnings
Earnings are essential for a stock to be considered a good investment. Without earnings, it is difficult to evaluate what a company is worth, except for its book value. While current earnings may have been overlooked during the internet stock boom, investors, whether they knew it or not, were buying stocks in companies that were expected to have earnings in the future.
Earnings can be evaluated in any number of ways, but three of the most prominent metrics are:
Earnings growth
Earnings growth is usually described as a percentage in periods like year-over-year, quarter-over-quarter and month-over-month. The basic premise of earnings growth is that the current reported earnings should exceed the previous reported earnings.
While some may say that this is backward-looking and that future earnings are more important, this metric establishes a pattern that can be charted and tells a lot about the company's historic ability to grow earnings.
While the pattern of growth is important, like all other valuation tools the relative relationship of the growth rate matters as well. For example, if a company's long-term earnings growth rate is 5 per cent and the overall market averages 7 per cent, the company's number is not that impressive.
On the flip side, an earnings growth rate of 7 per cent when the market averages 5 per cent establishes a pattern of growing earnings faster than the market. This measure on its own is only a start, though - the company should then be compared to its industry and sector peers.
Earnings stability
Earnings stability is a measure of how consistently those earnings have been generated. Stable earnings growth typically occurs in industries where growth has a more predictable pattern.
It is important to verify where the stability is coming from when comparing one company to another.
Earnings quality
Quality of earnings factors heavily into the evaluation of a company's status. This process is usually left to a professional analyst, but the casual analyst can take a few steps to determine the quality of a company's earnings. For example, if a company is growing its earnings but has declining revenues and increasing costs, you can be guaranteed that this growth is an accounting anomaly and will most likely not last.
Return on equity
Return on equity measures the effectiveness of a company's management to turn a profit on the money that its shareholders have entrusted it with. ROE is calculated as follows:
ROE = Net Income / Shareholders' Equity
ROE is the purest form of absolute and relative valuation and can be broken down even further. Like earnings growth, ROE can be compared to the overall market and then to peer groups in sectors and industries.
Obviously, in the absence of any earnings, ROE would be negative. To this point, it is also important to examine the company's historical ROE to evaluate its consistency. Just like earnings, consistent ROE can help establish a pattern that a company can consistently deliver to shareholders.
Relative value
While all of these characteristics may lead to a sound investment in a good company, none of the metrics used to value a company should be allowed to stand alone. Don't make the common mistake of overlooking relative comparisons when evaluating whether a company is a good investment.
Where to find information
In order to compare information across a broad spectrum, data needs to be gathered. The internet can be a good place to look, but you have to know where to look. Since the majority of information on the internet is free, the debate is whether to use the free information or subscribe to a service.
A rule of thumb is the old adage, "You get what you pay for." For example, if you are looking at comparing earnings quality across a market sector, a free website would probably provide just the raw data to compare. While this is a good place to start, it might behoove you to pay for a service that will "scrub" the data or point out the accounting anomalies, enabling a clearer comparison.
Conclusion
While there are many ways to determine if a company that is widely regarded as "good" is also a good investment, examining earnings and ROE are two of the best ways to draw a conclusion.
Earnings growth is important, but its consistency and quality need to be evaluated to establish a pattern.
ROE is one of the most basic valuation tools in an analyst's arsenal, but should only be considered the first step in evaluating a company's ability to return a profit on shareholder's equity.
Finally, all of this consideration will be in vain if you don't compare your findings to a relative base. For some companies, a comparison to the overall market is fine, but most should be compared to their own industries and sectors.
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