I've been getting back to the basics lately, most recently wrapping up a two-part discussion about how to find investment ideas.
But now we reach a critical point. You’ve got a pile of investment "ideas" in front of you, but how do you figure out which of those ideas are worthy of your investment dollars?
The four-point plan
Last week, I reviewed the four primary components of stock returns: growth, valuation, dividends, and share count. If our goal is to buy stocks that will earn attractive returns (and that certainly seems like a good goal), then estimating how each of these pieces is going to move in the future is a simple approach to figuring out whether that stock winking at you from over in the corner is worth taking home.
My, what big earnings you'll have!
Starting from the top, we need to get an idea for how fast earnings will grow. Let's break this down by way of an example.
Information technology consulting company Cognizant Technology Solutions (Nasdaq: CTSH ) has been an incredible growth story over the past decade -- both its revenue and profits have grown by about 3,200%. That growth led to an amazing 2,300% return for investors (that's 37.5% per year!), even though some of the other four points pulled slightly in the opposite direction.
Can Cognizant continue that growth and keep investors grinning from ear to ear? I generally look in three places to figure this out.
- Analysts' estimates: For many companies, Yahoo! Finance helpfully lists the average of Wall Street analysts' estimates for future growth. By looking here (toward the bottom of the page labeled "Next 5 Years"), we can see that analysts are expecting Cognizant to grow roughly 20% per year over the next five years. That's well short of the 40%-plus rate of the past decade, but it's still a very healthy growth rate.
- History: Industries are always in motion, the economy shifts, and companies change, but I still find it helpful to ground myself in a company's historical growth when considering what it may do in the future. In the case of Cognizant, we already know that it was able to crank out an earnings CAGR of more than 40% over the past 10 years, but it's continued to deliver strong growth more recently. As we can see on the stock's CAPS page, it's grown earnings per share 37% over the past year, and 27% and 33% per year over the past three and five years, respectively.
- Does it make sense?: So far it's been pretty easy since we've simply gathered some readily-available data, but here's where you need to get those brain cells firing and get down with some research. In short, what we want to do here is use an understanding of the business, the industry, competition, and any other relevant factors to make a determination of whether the growth rates we've laid out above really make sense.
While I'm not going to run through this in full here, a few things that you'll want to consider with Cognizant are:
- It operates in the massive and growing IT services industry, which gives it plenty of potential room for growth.
- There are some heavy hitters in the industry including Infosys (Nasdaq: INFY ) , Wipro (NYSE: WIT ) , Accenture (NYSE: ACN ) , and IBM (NYSE: IBM ) , all of whom will compete for customers.
- The company is heavily exposed to financial services companies, which could lead to slower growth if that sector continues to struggle.
- Even more generally, the company depends on business spending, which could be sluggish if the economy continues to limp along.
So what does this all add up to? We've got analysts estimating 20% growth, and historical growth suggests that that's definitely achievable. The forces working against the company may be particularly strong in the year ahead -- management only projects 14% earnings per share growth in 2011 -- but as I'm optimistic about a continued economic recovery, I think those pressures should let up over the next couple of years. Overall, it seems like 20% growth looks pretty reasonable for Cognizant.
One isn't enough
This is the future we're talking about here, and unless you have a crystal ball, it's unlikely that you're going to be able to come up with a single, perfect estimate for a company's future growth. For that reason, it's best to consider a range of possibilities and how they would impact your investment.
Even though we can justify our expectations for Cognizant, it's no easy feat -- to say the least -- to expect a $23 billion company to grow 20% per year for five years. Taking that into consideration, I would probably use 20% as the top end of my range. If profit per share really does grow just 14% in 2011, that would be the lowest growth rate for the company since, well, ever. I'd set that as the bottom end of my range and split the difference with 17% in the middle.
This range could end up underestimating Cognizant if it cranks growth back up to historical levels. On the other hand, it doesn't consider a truly disastrous scenario. The idea is to try to capture the most likely range of outcomes.
At this point, you have a four-point plan for figuring out a stock's potential returns using growth, valuation, dividends, and share count, and you've got a basic framework for pinning down a company's potential growth.
Next week, we'll turn to wacky world of valuations. But until then, head down to the comments section and hit me with any questions you have or share some of your growth-estimation work.
And if you've just tuned into this "back to the basics" series, you can get fully up to speed quickly: