Do you think analyzing stocks is too difficult? It doesn’t have to
be. Morningstar provides tools that make it easy. Here are five
tests that you could easily run using Morningstar to evaluate stocks
like a pro. These tests work best on manufacturing and service
stocks, but not so well on banks and other financial firms.
Start by getting a price quote on Morningstar’s home page (www.morningstar.com).
Then select “Financials”
from the menu below the company name. If you’re not already there,
select the Five-Year Annual Income Statement with “$” highlighted in
the View menu. Morningstar will display income statement data for
the past five fiscal years and for the last 12-months (TTM). Start
with top line, which displays revenues (sales) for each period.
#1) Revenue Growth
You’ll always do the best by owning stocks with the strongest
earnings growth. However, in most instances, a company must first
grow its revenues (sales) before it can grow earnings. Start with
the earliest year displayed (left-hand column) and look for steadily
increasing numbers. Acceptable growth depends on the industry. Hot
tech stocks should be growing revenues at least 20%
annually, but 5% to 10%
growth is okay for stocks in more established industries. Avoid
stocks with declining revenues.
Next, click on “%” in the View menu, which changes the display of
the income statement items from dollars to a percentage of the
corresponding year’s revenues.
#2) Gross Margin
Gross Profit is the profit that a company makes on its products
considering only manufacturing costs. Gross profit is termed “gross
margin” when it’s viewed as a percentage of sales as we’re doing
In any given industry, you’ll do best owing the stocks with either
the highest gross margins, or those with steadily increasing gross
margins. So, favor stocks with those characteristics.
#3) Operating Margin
A company can generate strong gross margins, but then fritter that
advantage away by spending too much on research, marketing,
administrative, and other overhead expenses. Checking operating
margins (operating income percentage of revenues), which are gross
margin minus overhead expenses, will tell you if that’s happening.
As was the case with gross margins, your best bets will either be
stocks with high operating margins compared to other industry
players, or those with steadily increasing operating margins.
Stock prices usually reflect a company’s historical and expected
future earnings per share (EPS) growth. Stocks with a solid track
record of consistent historical EPS growth are likely to continue
their winning ways. So, favor stocks showing steadily increasing
EPS. Stocks that have done the best on tests #1, #2, and #3 should
look good here. All that said, earnings numbers could have been
skewed by questionable accounting decisions and may not give a true
picture. That’s why it’s important to check cash flow as well.
#5) Cash Flow
Operating cash flow measures how much cash actually moved into or
out of a firm’s bank accounts resulting from its operations. Select
Flow” from the Statement Menu to see what’s happening in that
regard. The cash flow statement shows the net income for each period
on the top line and the “net cash provided by operating activities
(operating cash flow) about 14 lines below.
Because net income is reduced by non-cash bookkeeping entries such
as depreciation, operating cash flow should always be greater than
the corresponding net income. Something’s amiss if it isn’t. So,
favor stocks whose operating cash flow consistently exceeds net
income for the same year. For stocks meeting that requirement,
operating cash flow should more or less track net income growth.
Avoid stocks whose net income is growing much faster than operating
Relying on numbers alone never tells you the whole story. In the
stock market, as in life, a little common sense goes a long way.
Keep up with the news and focus on stocks operating in strong
sectors. In this environment, that translates to favoring stocks
mostly tied to the U.S. economy.