Evaluating stocks is an involved process and not something to be taken lightly or oversimplified. An important point to remember is that if something appears to be 'too good to be true' then it probably is. The market has a way of evening itself out to equilibrium and offering identical value across the board, since it has limited or no knowledge of the future. An example of this might be a very high yielding stock, a technology company with unbelievable earning growth, or a value trap (a stock that appears cheap, but is cheap for a valid reason).
Why is earnings growth the most important factor when evaluating a stock?
1. Earnings growth drives up a company's share price more than any other factor. Even if a stock is experiencing (P/E) multiple contraction, earnings growth will eventually cause share price to rise, it must be this way because mathematically it has to. An example of this is General Electric (GE) from 1999 to now. If GE's share price did not start rising from 2003 - now, their P/E would have fallen to very low levels, which investors would have never let happen. If earnings growth continues for long periods then there is nothing that will hold a stock's price back from rising, short of multiple contraction. Similarly I see this situation developing soon with Walgreens (WAG). WAG continues to pump out superb earnings growth but the stock just sits there, this trend can only continue for a limited time, which is obviously one of the reasons that I am so bullish on the stock as readers of this blog know very well.
2. Earnings growth supports, and actually allows for dividend increases. When a company earns more money quarter after quarter, that gives them the confidence and resources to pay an ever increasing dividend, which should also provide a floor for the share price, if not cause the share price to rise. Conversely when a company has weak earning growth their share price will suffer, if they continue to raise the dividend their yield will rise, however, their pay-out ratio will rise at the same time. This trend can not continue forever, and eventually the company will have to slow dividend growth, freeze the dividend, or cut the dividend. For an example of this have a look at Loblaws (L) stock over the past 5 years. Loblaws is paying the same $0.21 per share dividend that it was paying in early 2005 (they've froze the dividend). During 2005 it was yielding 1.1%, it is now yielding 1.9%; does this make the stock more attractive now because the yield has almost doubled? Given that these are still relatively low yields but the same type of trend can and does happen with higher yielding stocks and the trend would have been much more severe if Loblaws continued to raise it's dividend over the past 2 years.
3. Earnings growth can show the quality of management. A large part of managing a company is reducing expenses, if a company can continue to grow earnings even when their top line is weaker, this shows that management has found a way to cut costs.
4. Earnings growth can show the strength of an industry. Usually if several companies in the same industry show slowing earnings growth it says something about the industry and vice versa for rising earnings growth.
What truly matters most in the process of selecting stocks is future earnings growth. Strong past earnings growth is great but it will not increase a company's share price and dividend payments going forward.
How do we determine future earnings growth?
This is the eternal question in the investing world because he who picks the stocks which grow their earnings the quickest for the longest sustained time - wins, no matter what your investment style is. Whether you are a growth investor, momentum investor, a value oriented investor, a yield investor, or a dividend growth investor, etc. you will come out ahead if you select the stocks with the highest sustained earnings growth rate going forward.
When is comes to determining future earnings growth you can look at a myriad of factors not limited to analyst estimates, economic conditions, company specific initiatives, demographics, industry fundamentals, the list goes on and on...
If it was easy to determine what the future earnings growth rate was then we would all be millionaires. The fact that it is difficult is no surprise. This is what makes a market, this is uncertainly, this is investing....