Harry Domash's Winning Investing


Be Your Own Stock Analyst

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 here.

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.

#4) Earnings
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 “Cash 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 cash flow.

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.

published 4/4/14

Questions or comments about this site: click here

Winning Investing    199 Quail Run Road  Aptos, CA 95003

(Aptos is 'the beach' for Silicon Valley)

(800) 276-7721 • (831) 685-1932