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2001 BW 50



Finding Stocks You Can Trust
How to tell whether a company's strong performance is for real or boosted by accounting gimmicks

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Has selecting stocks ever been trickier? After Enron, investors feel they can no longer trust CEOs to talk straight, Wall Street analysts to provide an honest reading of a company, or reported earnings to reflect reality. Other worries: shriveling profits, a spike in corporate bankruptcies, and an economy struggling to get on its feet. If there's a silver lining, it's this: Investors have learned the importance of bringing a healthy dose of skepticism to the table.

But skepticism only goes so far. What investors require more than ever are guidelines to help them separate worthy companies from the pretenders. That's because only the strongest, most ethical companies will survive today's tough times. We are talking about companies with solid business models, top-notch management, and abundant potential. These companies are in a variety of industries, including financial services, health care, and consumer products. Growth companies come in all sizes, from household names such as PepsiCo (PEP ) to up-and-comers like Activision (ATVI ), a maker of hot video games based on such extreme sports as snowboarding.

We've outlined five key criteria for you to take into account when you're trying to identify companies with outstanding growth prospects. These measures, which include revenues, earnings, and cash flow, aren't fail-safe. But if you apply them in the rigorous manner that we detail in this article, they will help you get a feel for whether a company's strong performance is for real or merely inflated by accounting gimmicks.

You'll also want to do a little sleuthing on your own. By visiting corporate Web sites, you can gain access to financial statements, management speeches, and replays of conference calls between company executives and Wall Street analysts.

The reports of these analysts can also be a good source of information. Keep in mind, however, that brokerage firm stock analysts tend to be overly optimistic, especially about companies that give investment banking business to their firms. Rely on your gut, too. If a company's numbers seem too good to be true, they probably are. Lastly, if you don't understand what the company does, or its financial disclosures fall short, simply move on.

1. REVENUE GROWTH In a low-inflation world, raising prices to plump up profits isn't an option for most companies. That's why strong, sustainable sales growth is so important.

Companies that flourish in a challenging environment deliver great products and services. Take pharmaceutical giant Johnson & Johnson (JNJ ), which has enjoyed 69 consecutive years of sales increases, most recently fueled by blockbusters like the antipsychotic drug, Risperdal. And look at Wal-Mart Stores (WMT ), the nation's largest retailer. Wal-Mart is in a virtuous circle. Because of its size, it has clout with manufacturers, allowing it to buy in large enough quantities to offer consumers rock-bottom prices. Its low prices and wide variety draw customers, which in turn drives sales.

What kind of top-line growth should you look for? A defining attribute of a growth company is that its revenues grow at a pace greater than that of the overall economy. Given that the gross domestic product is expected to increase at a 3% average annual pace over the next three years, sales growth above that rate is attractive. Charles Carlson, contributing editor of the investment newsletter Dow Theory Forecasts, advises investors in large companies to seek out those that are able to expand sales at a 6% to 8% pace over the next three years. With smaller companies, the hurdle should be higher--say, 9% to 12%--since smaller companies typically grow faster than larger ones.

Many investors also prefer to examine sales instead of earnings because they're harder to manipulate. Still, even with sales, you have to do a reality check. For instance, look to see if sales and inventories are growing at similar rates. (You can find that in the quarterly financial statements called the 10-Q, and annual financial statements, the 10-K, which the company files with the Securities & Exchange Commission.) You can find these documents on the SEC's EDGAR Web site.

What if you see that inventories jumped 12% last year, while sales grew at 9%? It could be sign that the company misread demand for its products, causing goods to languish on warehouse shelves. Of course, there could be a more benign explanation. The company may be building inventories it needs to launch a new product. The annual report's "Management Discussion and Analysis" section should tell you if that's the case.

Another caveat: Be wary of companies whose revenues are growing primarily through acquisitions. It's rare for corporate marriages to reward investors over the long haul. Among the largest global mergers between 1997 and 1999, only 30% increased shareholder value, according to a study by accounting firm KPMG. Also, it's easy for acquirers to manipulate complicated financial statements to camouflage blunders. Tyco International (TYC ) became a Wall Street darling in the 1990s as its revenues soared through aggressive acquisitions. Now, investors are wary of serial acquirers' financials, so Tyco is doing a 180-degree turn and plans to split into four pieces.

2. EARNINGS GROWTH Today, the quality of earnings is a paramount consideration. After the dot-com bust, investors were already getting suspicious of pro-forma earnings statements that companies were foisting on them, hoping to spin their numbers in the best possible light. Now, even companies that follow traditional generally accepted accounting principles (GAAP) are finding that's no longer enough. Blue chips such as IBM (IBM ) and General Electric (GE ) are releasing more financial data than ever, in part, to allay investor skepticism about how the numbers are put together.

How can you tell if a company is puffing up profits? Sales drive earnings, so both should rise at around the same pace each year. Thus, if you notice that a company's sales rose 10% last year but earnings jumped 20%, other factors are at work. Lehman Brothers accounting analyst Robert Willens says the discrepancy could be a sign that the company has overdone cost-cutting or sold off assets such as business units or patents. Both moves would give a short-term boost to profits but crimp sales and earnings over time. Of course, there could also be a positive reason for profit growth to outpace sales. The company might have raised the prices of its goods or services or boosted productivity, resulting in fatter profit margins.

If a company liberally hands out stock options to its employees, its earnings probably look better than they really are. Current accounting rules don't require companies to list stock options grants as an expense when they calculate their earnings. However, the SEC does require companies to estimate the impact of these options on the bottom line. You'll find the stock options information in a footnote in the annual report, which most companies issue in the spring. David Zion, an accounting analyst at Bear Stearns, estimates that the earnings for the companies in the Standard & Poor's 500-stock index would have been an average of 9% lower in 2000 if employee stock options had been expensed.

3. CASH FLOW Some investors believe cash flow is a better gauge than earnings and sales of how well a company is performing because it is less open to accounting distortions dictated by GAAP. Cash flow is what a company earns before accountants subtract the intangible costs of depreciation and amortization. If you owned the neighborhood candy store, all you would care about at the end of the day was how many dollars were in the cash register, less what you owed for expenses. That's cash flow.

Net income and cash flow should rise by roughly the same percentage each year. To compare the two, check the company's latest 10Q or 10K filings. You'll find net income at the bottom of the income statement. Cash flow is on a line called "cash from operating activities."

If earnings are growing much faster than cash flow, it could be a red flag. That's because companies record the revenue when they ship the goods--but before customers pay. The cash flow statement reflects how much money is collected. So if earnings soar but collections stall, it could be a sign that future earnings are at risk of being dragged down by bad debt.

Conversely, if cash flow is suddenly growing much faster than earnings, the company may be deferring spending on plant and equipment to cut costs, says Lehman Brothers' Willens. That move could eventually lower productivity.

4. DEBT Corporate credit quality is a big concern these days. Of the 15 largest business bankruptcies since 1980, seven were in the past year, including Global Crossing, and Enron--the biggest Chapter 11 filing in history. Bankruptcies among public companies hit a record 257 in 2001, up from 176 a year earlier, according to BankruptcyData.Com. All of them arise from a company's inability to meet its debt obligations.

There's nothing wrong with borrowing--it's when the borrowing becomes excessive that problems arise. Tapping outside financing to fund growth is crucial for expansion, especially in a company's early stages. The trouble is that corporations went on a borrowing binge during the 1990s. Not all of it was done to build the business. Much borrowing was done to finance corporate share repurchases. Buybacks help reduce outstanding shares, lift earnings-per-share figures, impress Wall Street--and boost share prices.

How much debt is too much? First, look at capital, which is long-term debt plus shareholder equity. As a rule of thumb, the debt should be less than 50% (table). But it's best to compare companies in the same industry. In cyclical industries like paper and chemicals, where revenues can swing wildly, the less debt the better. Industries with stable revenues, like old-fashioned utilities, or those that generate lots of cash, like supermarkets, can service more debt. Lehman Brothers' Willens likes to see companies with total debt burdens that are less than 40% of the market capitalization. To figure a company's market cap, multiply shares outstanding by the current share price.

Another way to determine if a company can cover interest payments on its debt is to calculate "interest coverage." This is a ratio of earnings before interest, taxes, depreciation, and amortization (EBITDA) divided by the company's annual interest payments. "A company should have five times or more interest coverage for a level of comfort," says Kenneth A. Shea, director of equity research at Standard & Poor's. He notes that General Mills has a stiff debt-to-capital ratio of 82%, thanks to its acquisition of Pillsbury last year. But because the cereal maker generates lots of cash, it can more than meet its debt obligations; its interest coverage is 7.

5. VALUATION Once you've found a great company, ask yourself: Is its stock fairly priced? If the share price is relatively rich, your investment return may be limited. To find reasonably priced growth stocks, use a common valuation tool called the price-to-earnings ratio. A stock's p-e ratio is its share price divided by earnings per share. Most often, the earnings number used in the equation is a consensus forecast for a company's operating earnings over its current or coming fiscal year.

Many stock-pickers look at a stock's p-e relative to its industry peers, its own historical ratio, and the expected rate of its earnings growth over the next five years. During much of the 1990s, growth-stock afficionados sought stocks with a p-e less than or equal to its expected annualized five-year growth rate. So a 35 p-e looked cheap if the company was expected to grow 40% (table).

In today's tough business environment, "you need to pay a higher premium for sustainable growth," says Larry Puglia, portfolio manager of the T. Rowe Price Blue Chip Growth Fund. As a result, Puglia believes it's reasonable to pay a premium for the best growth stocks--as long as it isn't too steep. One top-notch growth stock that Puglia likes is Pfizer, whose p-e ratio was recently at 22, vs. its estimated 15% annual average five-year growth rate.

The problem with a p-e valuation analysis is the "e." Even when a company is completely forthright, it's tough to get estimates right. Another dilemma: Wall Street analysts have a lot of leeway in calculating operating earnings. Operating earnings generally exclude one-time charges for events such as layoffs and inventory reductions, which makes results look better. Some growth managers think a better valuation tool is the price-to-sales ratio, which is the stock's price divided by revenues per share. That's because sales are less susceptible to manipulation than earnings.

During the 1990s, it seemed that you could find a winning stock by throwing a dart at the New York Stock Exchange and Nasdaq listings. But investing was never that easy, a lesson driven home by the bear market of the past two years. To succeed, you must map out a sound plan, based on research and common sense, and stick to it.

APRIL 2, 2002

By Susan Scherreik

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