Introduction
FUNDAMENTAL ANALYSIS, WHICH makes use of accounting numbers, allows the best quality companies to be selected from our screened lists of income, value and growth companies. The first set of checks involves looking at historic and forecast earnings.
Earnings information
Earnings information is available on the Morningstar website, which conveniently lists the normalised and reported earnings per share (EPS) over the past ten years. EPS is net income divided by the number of shares outstanding. Reported EPS uses reported earnings in the nominator of the calculation, while normalised EPS uses normalised earnings in the nominator. Normalised earnings exclude anything that is an unusual one-time event, making it easier to identify earnings from core operations.
These figures can be found by entering the company name into the search box at the top of the Morningstar home page. A list of companies that match your search will appear. Selecting a company name will bring up the overview section of the company profile. Both normalised and reported EPS figures for the past ten years can be found on the income statement in the financial section of the company profile.
Paid for data providers (such as Stockopedia, ShareScope and Zacks) also provide consensus broker earnings forecasts for normalised EPS and net profit over the next two years.
Positive earnings
The first thing to assess is whether the company can consistently make a profit. Looking at a company’s earnings history will reveal this. Remove any shortlisted companies that have reported a negative normalised or reported EPS figure in the past five years. The preferred trend is for earnings to be positive and steadily rising over the past ten years.
The earnings score counts the number of years where reported and normalised EPS have been positive over the past ten years. Our preference is to invest in companies with a high earnings score of 16 or higher, as these companies are more likely to be consistently profitable.
Example
Table 3.1 shows the earnings history for XP Power, which was selected as an income company. The net profit (also referred to as net earnings or net income) has been positive over the past ten years, indicating that the company is able to consistently make a profit.
Net profit rose until 2011 (ignoring the blip in 2009 because of the financial crisis). Earnings fell in 2012 due to temporary weakness in global demand and then gradually recover. Net profits in 2017 are 3.2 times those in 2008.
Similarly, reported and normalised EPS were positive for each of the past ten years. The earnings score is therefore 20. The normalised earnings trend has been volatile, but the underlying trend is upward.
Table 3.1 Earnings per share (EPS) history – XP Power
|
2008 |
2009 |
2010 |
2011 |
2012 |
2013 |
2014 |
2015 |
2016 |
2017 |
|
|
Net Profit (£m) |
8.8 |
7.4 |
15.8 |
20.3 |
15.5 |
18.2 |
19.4 |
19.7 |
21.3 |
28.3 |
|
Reported EPS (p) |
46.5 |
39.4 |
83.9 |
107.1 |
81.7 |
95.8 |
102.1 |
103.7 |
112.0 |
148.3 |
|
Normalised EPS (p) |
46.4 |
39.3 |
83.2 |
106.4 |
81.3 |
95.1 |
101.1 |
102.8 |
111.2 |
146.0 |
Earnings growth
Earnings growth is the annual rate of growth of earnings. This measure ensures that the company becomes more valuable over time and that the share price will eventually appreciate. In addition, for income companies, an increase in earnings ensures that dividends will continue to be paid and that there is greater scope to increase dividends paid out in the future.
Normalised earnings are used to assess earnings growth as this measure excludes exceptional items. Growth companies should have strong earnings growth, at more than 15% per annum over the past five years – anything less and the company is not growing fast enough and should be removed from the shortlist.
For income and value companies you want to select companies that have sustainable earnings growth, with earnings growing between 3% and 15% per annum over the past five years. This makes it more likely that dividends and/or value will be grown over time.
Remove shortlisted companies, whose normalised earnings growth is less than 3% over five years, as you want companies that increase earnings faster than long-term inflation. Equally, companies that are growing over 15% per annum are in a growth phase, which may not be sustainable. If five-year earnings growth is in excess of 15% per annum look at earnings growth over ten years (or the longest history available) and ensure this is also in excess of 5%.
Example
Normalised earnings growth for XP Power is summarised in table 3.2. Looking at table 3.1, the five-year compound annual growth rate (CAGR) for normalised earnings is 12.4% (= (146.0 ÷ 81.3)(1/5) − 1). This is higher than our cut-off point of 3% growth and the CAGR of earnings from 2008 to 2017 was 13.6% (= (146.0 ÷ 46.4)(1/9) − 1). Note XP Power had strong earnings growth in 2017 due to a sharp global upturn in trading conditions, which boosted earnings by more than 30%.
Table 3.2 Annualised EPS growth – XP Power
|
Annualised EPS Growth (%) |
|
|
1 Year |
31.3 |
|
3 Years |
13.0 |
|
5 Years |
12.4 |
|
9 Years |
13.6 |
Broker views – Future expected earnings growth
If broker forecasts for future EPS growth over the next two years are positive, it indicates that the market expects the company’s profits to grow over the near term.
For income or value companies, check that the consensus forecasts are higher than the latest EPS available. Ideally, prospective EPS growth should be more than inflation (3%) and preferably above 5%, but it is not a prerequisite. A company with low earnings growth is factored in when estimating the underlying broker value of the company. (Broker valuations are discussed in chapter 11.)
Example
Broker forecasts of earnings growth for XP Power are shown in table 3.3. Broker consensus expect earnings to grow by 20.6% in 2018 and by 7.7% in 2019. Earnings growth is therefore expected to be comfortably above the 3% hurdle.
Table 3.3 Broker forecasts – Earnings growth for XP Power
|
2017 |
2018 (f) |
2019 (f) |
|
|
Normalised EPS (p) |
146.0 |
176.0 |
189.5 |
|
Earnings Growth (%) |
31.3 |
20.6 |
7.7 |
(f) indicates broker forecasts, taken at December 2018
For growth companies, consensus broker forecasts should expect growth to continue. If brokers don’t anticipate decent earnings growth, there may be a problem with the investment thesis for continued growth.
Consensus broker forecasts should suggest prospective EPS growth above 10% per annum over the next two years. Remove growth companies from the shortlist that are not growing normalised earnings fast enough. In addition, remove companies if their EPS has not risen over the latest four years of numbers available (including the two years of broker forecasts).
Example
Table 3.4 shows the consensus broker forecasts for growth company Bloomsbury Publishing. Normalised EPS has increased each year since 2014, except for 2017. This fall in earnings in 2017 is attributable to increased investment in the development of new digital content to support future growth and the ending of a contract with the Qatar Foundation.
Broker consensus expects earnings to grow by 18.2% in 2019 and 13.3% in 2020. This equates to earnings growth of 15.7% per annum over the next two years, well above the 10% growth hurdle. EPS is expected to reach a new high of 16.2p by 2020, which implies earnings are expected to grow relative to the 2016 level.
Table 3.4 Broker forecasts – Earnings growth for Bloomsbury Publishing
|
2014 |
2015 |
2016 |
2017 |
2018 |
2019 (f) |
2020 (f) |
|
|
Normalised EPS (p) |
11.3 |
12.7 |
14.0 |
10.8 |
12.1 |
14.3 |
16.2 |
|
Earnings Growth (%) |
12.4 |
10.2 |
-22.9 |
12.0 |
18.2 |
13.3 |
(f) indicates broker forecasts, taken at December 2018.
Stockopedia provides a summary of how much broker forecasts have changed over the past month and three months. Upward revisions in earnings are desirable as they indicate that market sentiment has turned more positive on the earnings potential of the company, which is supportive of upward price momentum. Conversely, downward revisions may reflect the market turning more negative on the earnings potential of a company, which may lead to some price weakness.
Example
Table 3.5 shows the change in broker earnings forecasts for XP Power in 2018 and 2019 in December 2018. Earnings forecasts are positive for 2018 but negative for 2019, indicating that market consensus has turned less positive on the company’s earning potential for 2019.
Table 3.5 – Detailed broker forecasts – XP Power
|
31st December 2018 |
31st December 2019 |
|||||
|
Net Profit (£m) |
DPS (p) |
EPS (p) |
Net Profit (£m) |
DPS (p) |
EPS (p) |
|
|
Consensus |
32.4 |
82.4 |
176.0 |
36.3 |
87.5 |
189.5 |
|
1m Change |
0.0% |
0.0% |
0.0% |
0.0% |
0.0% |
0.0% |
|
3m Change |
-2.0% |
1.2% |
0.1% |
-2.2% |
-0.4% |
-3.6% |
Pre-tax profits
Pre-tax profits exclude the effects of tax, which vary from year to year due to different tax allowances. Declining pre-tax profits (or declining pre-tax profit margins) can quickly translate into declining EPS and a falling share price. We therefore require that pre-tax profit grows by more than 3% per annum over the past five years for income or value companies, or more than 15% for growth companies. Broker forecasts for pre-tax profit growth should be in line with prospective EPS growth. Companies should be removed from the shortlist if pre-tax profits are not growing sufficiently.
Example
Table 3.6 shows the available history of pre-tax profits for XP Power. Pretax profits have not risen every year, but the underlying trend is upward.
Pre-tax profits rose from £20.2m in 2012 to £32.2m in 2017. This equates to a 9.8% (= (32.2 ÷ 20.2)(1/5) – 1) rise over the past five years. Pre-tax profits are expected to rise by 23.2% (= 39.7 ÷ 32.2 – 1) in 2018 and by 11.3% (= 44.2 ÷ 39.7 – 1) in 2019. Pre-tax profit growth is therefore expected to be above the 3% hurdle.
Table 3.6 Pre-tax profit – XP Power
|
2010 |
2011 |
2012 |
2013 |
2014 |
2015 |
2016 |
2017 |
2018 (f) |
2019 (f) |
|
|
Pre-Tax Profit (£m) |
18.6 |
24.3 |
20.2 |
22.9 |
24.3 |
25.4 |
27.8 |
32.2 |
39.7 |
44.2 |
(f) indicates broker forecasts, taken at December 2018.
In general, you should look for companies that are not valued at more than 15 times current pre-tax profits. Companies that have a market value above 15 times current pre-tax profits are viewed as expensive and are removed from the shortlist.
Example
The market capitalisation of XP Power mid-December 2018 was £434.7m. This market value is 13.5 (= 434.7 ÷ 32.2) times 2017 pre-tax profits. Broker consensus is that this multiple will fall to 10.9 times in 2018 and to 9.8 times in 2019. Market value is less than 15 times current pre-tax profits and, based on this metric, XP Power is not viewed as expensive.
Pre-tax profit margins, defined as pre-tax profits divided by revenue from sales, should be stable or gradually rising. A sharp fall in profit margins is a warning sign of further potential trouble ahead. If pre-tax profit margins have fallen sharply in the latest reported year, the company can be removed from the buy list.
Example
Pre-tax profit margins for XP Power are calculated in table 3.7. Pre-tax profit margins have remained reasonably stable, ranging between 19.3% and 24% in 2010–2017. Profit margin for 2017 was weaker than previous years. However, broker consensus expects profit margins to be close to or above 20% in 2018–2019.
Table 3.7 Pre-tax profit margin – XP Power
|
2010 |
2011 |
2012 |
2013 |
2014 |
2015 |
2016 |
2017 |
2018 (f) |
2019 (f) |
|
|
Norm. Pre-Tax Profit (£m) |
18.6 |
24.3 |
20.2 |
22.9 |
24.3 |
25.4 |
27.8 |
32.2 |
39.7 |
44.2 |
|
Revenue (£m) |
91.8 |
103.6 |
93.9 |
101.1 |
101.1 |
109.7 |
129.8 |
166.8 |
199.0 |
212.8 |
|
Pre-Tax Profit Margin (%) |
20.3 |
23.5 |
21.5 |
22.7 |
24.0 |
23.2 |
21.4 |
19.3 |
19.9 |
20.7 |
(f) indicates broker forecasts, taken at December 2018
Earnings valuation
The prospective PE ratio (also referred to as the forward PE ratio) is price divided by the consensus forecast for EPS over the next 12 months. For income or value companies, a prospective PE ratio of 20 or more is considered expensive and is removed from the shortlist. Companies with a PE ratio below 5 are removed from the watch list, as PE ratios below this level are generally indicative of severe problems or concerns over the long-term viability of the company.
Example
The share price of XP Power was 2130p towards the end of December 2018. Using the normalised EPS figures in table 3.3, the current and prospective PE ratios can be calculated. These are shown in table 3.8. The current PE ratio is 14.6 (= 2130 ÷ 146). Using this metric, XP Power does not look too expensive. Anticipated EPS growth is expected to lead to an improved valuation over the next two years. The company’s PE ratio is expected to fall to 12.1 based on forecast EPS for 2018 and to 11.2 based on forecast EPS for 2019.
Table 3.8 PE ratios – XP Power
|
Ratio |
2017 |
2018 (f) |
2019 (f) |
|
PE Ratio |
14.6 |
12.1 |
11.2 |
(f) indicates broker forecasts, taken at December 2018.
In general, for income and value companies a PE ratio in high single digits or low double digits is preferred. However, for growth companies, the prospective PE ratio may be high because earnings are growing rapidly. For growth companies, a prospective PE ratio of 40 or more is considered expensive and is removed from the shortlist.
The prospective price-earnings growth (PEG) rate is an alternative valuation measure that aims to take account of earnings growth. It is defined as prospective price to earnings divided by future earnings growth.
In general, a PEG below 1 is deemed to offer excellent value, while a PEG between 1 and 1.5 offers good value. A PEG between 1.5 and 2 is considered average, while a PEG above 2 is considered poor value.
For large cap companies (such as those listed on the FTSE 100) a prospective PEG of 0.75 or lower is considered to be undervalued, while for mid to small cap companies (such as those listed on the FTSE 250 of FTSE small cap) a prospective PEG of 0.6 or lower is required, to offset the additional associated risks. If the PEG is below 0.3 the valuation is considered ‘too good to be true’ and the company is removed from the watch list.
Example
PEG ratios for XP Power can be calculated from the PE ratios in table 3.8 and the earnings growth numbers in table 3.3. The current PEG ratio is 0.5 (= 14.6 ÷ 31.3), which implies that the PE ratio is two times earnings growth. The prospective PEG rises to 0.6 (= 12.1 ÷ 20.6) for 2018 and 1.5 (= 11.2 ÷ 7.7) in 2019. This suggests that once earnings growth is factored in, the share price offers average value for 2019. If XP Power was a growth company, you would want to look at other companies in the sector which may offer better value. However, as XP Power is an income company you can put this down as a weakness and consider other checks and analysis when deciding whether to invest.
Table 3.9 PEG ratios – Company ABC
|
Ratio |
2017 |
2018 (f) |
2019 (f) |
|
PEG Ratio |
0.5 |
0.6 |
1.5 |
(f) indicates broker forecasts, taken at December 2018.
Summary
This chapter has covered a range of earnings and pre-tax profit checks that start to provide insight into the quality of earnings and value of a company.
Companies on the shortlist should ideally have the following characteristics:
Earnings checks
· Earnings positive and trending upwards over the past ten years.
· Normalised EPS numbers over the past five years are positive.
· Five-year average earnings growth is 15% or more for growth companies.
· Five-year average earnings growth is between 3% and 15% for income and value companies.
· Prospective earnings growth should be positive for income or value companies and more than 10% for growth companies.
Pre-tax profits checks
· For value or income companies, pre-tax profit should be growing by more than 3% per annum over the past five years.
· Pre-tax profit for growth companies should be growing by more than 15% per annum over the past five years.
· Broker forecasts for pre-tax profit growth should be in line with prospective EPS growth.
· Market capitalisation less than 15 times pre-tax profits.
· Pre-tax margins are stable or gradually rising.
Earnings valuations
· Current and prospective PE ratios between 5 and 20 for income and value companies.
· PEG ratio less than 0.75 for large growth companies, or less than 0.6 for small and medium growth companies.