Back

ESTIMATING GROWTH RATES. The concept of earnings growth is very simple, yet estimating growth rates can be terribly difficult. It’s like computing the gas mileage of your car. Calculating the MPG on a single tank of gas is very simple. But it can also be very misleading. Obviously, your average miles per gallon varies widely depending upon driving conditions and other circumstances. Companies like Walgreen and Stryker grow earnings at a nice steady pace so there’s very little problem estimating their growth rates. Other companies are like stop and go drivers. Their earnings go up and down in a hopelessly random fashion. Although it’s virtually impossible to predict the earnings of these erratic performers, you still need to have an idea of their earnings growth prospects.

Given the variety of factors and circumstances affecting earnings performance, a system of estimating earnings growth that virtually tailors growth estimates for each company is required. Take, for example, the simple step of selecting a time period for computing a growth rate. When should the period begin? Five, ten, fifteen years ago? When should it end? One, three or ten years from now? This single decision makes a major difference in the growth rate estimate you would obtain. Other critical issues like handling negative numbers, and dividing by zero make it easy to see why many growth rate estimates may be totally erroneous.

One of the worst examples of misleading growth rates appears in a popular financial magazine which publishes monthly lists of "America’s Fastest Growing Companies." These companies are defined as "showing at least a 200% gain in quarterly earnings." Sure, a company’s quarterly earnings may increase from one cent to three cents for a 200% gain, but does that mean it’s one of America’s Fastest Growing Companies? Give me a break!

Statistical analysis of historical data is required to properly determine earnings growth performance. Earnings performance data may be obtained from a company’s annual reports, or various financial services. Historical data is necessary but not sufficient. It only reflects the past. The stock market anticipates the future. Extrapolating the past to estimate future growth is a common and foolish mistake. You need forecasted growth rates to know where a company is heading.

VectorVest provides estimated growth rates for over 8,000 stocks every day. It statistically analyzes historical sales and earnings performance, takes into account current quarter-to-quarter changes in sales and earnings, and uses forecasted earnings to target future growth. VectorVest analyzes both sales and earnings to target future growth. VectorVest analyzes both sales and earnings data because they are linked in the long-term. Sales growth without accompanying increases in earnings growth reflects a loss of margin...a bad sign. Earnings growth without equivalent sales growth reflects cost cutting, productivity improvements and so on. These are good signs, but they can’t last forever. Clearly, there’s much more to estimating earnings growth than meets the eye.

USING GROWTH FORECASTS. Even a perfect growth estimate reflects conditions at a single moment in time. Therefore, it’s necessary to use these estimates with three considerations in mind. These are:

1. Sustainability,
2. Trend and
3. Variability.

SUSTAINABILITY. The mark of a great growth company is the ability to continue growing at a steady, predictable pace. The law of large numbers, however, dictates that extremely high earnings growth rates cannot be sustained. As a young company, Cisco Systems had an unbelievable run of triple digit quarterly gains. It was and still is a great growth company. But triple digit growth rates are no longer happening. The fruits of its own success made it so.

About 45 percent of the companies in our VectorVest database are currently estimated to grow at or above 14 percent per year. Many will still be growing rapidly ten years from now. Others will not. It takes phenomenal products, customer service and managements to grow at double digit rates for years on end. Walgreen and Stryker are prime examples of such great companies. They are literal money machines.

TRENDS. The transition from high growth to sustainable growth is a scary experience that usually causes considerable anxiety among investors. The slightest hint of an earnings slowdown causes a stock’s price to fall. A failure to meet an earnings forecast by as little as one cent often results in a 30 percent drop in price. No one knows for sure what company’s sustainable growth rate will be or when it will occur. Therefore, VectorVest updates its earnings estimates each week for every stock. VectorVest ProGraphics is the only software which allows you to see these trends on a chart.

Tracking growth trends may also reveal spectacular turn-around situations before they are generally recognized by the public. An unexpected increase in earnings performance often causes a stock’s price to soar. This can happen even if a company loses less money than it did the year before. So a reduction in negative growth can be just as important as an increase in positive growth.

VARIABILITY. The third important consideration in using growth rates is that of variability. Premier growth companies have a history of consistent, predictable financial performance. It is very easy to estimate the growth rates of companies like Walgreen and Stryker. These companies are called "Ruler Stocks" because their quarter-to-quarter earnings increase at a constant rate. You can lay a ruler along a plot of this data. Estimating that these companies will grow as they have in the past entails very little uncertainty.

The way to judge the variability, i.e., risk of a growth forecast is to examine VectorVest’s Relative Safety ratings. Stocks with Relative Safety ratings above 1.00 on a scale of 0.00 to 2.00 have above average financial performance. They also have less variability in their growth forecasts. Less than 10 percent of the stocks in our database have growth rates greater than or equal to 14 percent per year, and Relative Safety ratings of 1.00 or over. Your chances of finding a "Ruler Stock" are even less. Let’s see how this information can be used to build a variety of growth portfolios.

HIGH GROWTH STOCKS. Aggressive investors must deal with high growth stocks. The risks are high, but so are the potential rewards. Here’s a list of the five fastest growing stocks currently in VectorVest’s current database.

Value = $/share as computed by VectorVest
RS = Relative Safety
GRT = Earnings growth Rate in %/year
$DIV = Dividend in $/share
DY = Dividend Yield in Percent

Note the wide range of Price to Value comparisons among these stocks. This illustrates the uncertainty in assessing the potential of these companies. The low Relative Safety (RS) ratings also show the risks of dealing with unproven entities.

GROWTH & INCOME STOCKS. Conservative investors usually prefer to achieve their target level of total return by combining earnings growth with dividend payout. It’s OK to do this, but don’t take it too far. High yield without earnings growth is a loser's game. I suggest that the earnings growth rate of your stocks be at least double the dividend yield. For example, a portfolio offering 12 percent total return would have stocks with at least eight percent growth and four percent yield. In most cases, I tend to favor stocks with higher growth and less yield. Here’s a list of solid stocks with at least 11 percent growth and three percent yield. 

Note that these phenomenal stocks are ranked by RS times GRT. (Only VectorVest can perform this search for you). All of these stocks have favorable upside potential compared to an investment in AAA Corporate Bonds. Imagine seeing your money grow at an average rate of 25.2%/year with stocks in some of America’s best managed companies!

Coming up with these lists seems easy, but it’s the result of a lot of hard work. Fortunately, VectorVest does all the work. All I had to do was decide what to ask VectorVest to do.

When it comes to preserving and increasing your wealth, go with consistent, predictable growth. It’s the Golden Touch. 

Back