Numbers deserve scrutiny
If you’re a savvy reader, you don’t blindly accept much of what you read. Think critically about not just words, but numbers. They’re not always what they seem.
For example, many companies will report “record earnings.” This isn’t necessarily impressive. Whoa Nellie Brake Co. (ticker: HALTT), for example, might earn a record $5 per share in 2005. But if it earns $5.01 in 2006, $5.02 in 2007 and $5.03 in 2008, each of those will also be record earnings, but they’ll represent meager growth. You need to examine how quickly a company’s earnings are growing. But this alone isn’t enough, either.
Imagine Meteorite Insurance Inc. (ticker: HEDSUP), which reports that its revenues advanced 200 percent over the past year. That’s more telling than “record growth” and would intrigue most investors. Check to see what the actual revenue numbers are, though. Perhaps Meteorite has been struggling, and took in only $200,000 in 2004. Two hundred percent growth would put it at $600,000 in 2005. That’s still mighty tiny. It’s important to consider companies in the proper context. A behemoth such as Wal-Mart can’t double earnings as quickly as a small upstart can. It’s usually easier to double $5 million than $50 billion. As companies grow larger, expect their growth rates to slow down. They can’t triple each year forever.
Another potential danger is the “annualized” growth rate. When a company (or mutual fund) takes its total return over a number of years and annualizes it, it’s telling you how much it roughly earned, on average, per year. This is generally handy, but check what period of growth is covered. For example, if Monster Genetics (ticker: FSTEIN) increased its earnings from $0.12 per share in one year to $0.37 five years later, its annualized growth is about 25 percent. If One-Legged Chair Co. (ticker: WOOPS) doubled its earnings in three months, its annualized rate would be more like 1,500 percent. Annualizing a short period’s returns will magnify the numbers and can distort things. Those might have been extraordinary months.
Numbers can tell you a lot — if you look carefully.
Ask the Fool
Q: I know the market goes up and down because of the buying and selling of stocks, but who’s behind the buying and selling? — R.S., Opelika, Ala.
A: Many buyers and sellers are individual investors like us, placing small trade orders through our brokers. Then there are the institutional investors, such as mutual funds, pension funds, banks and insurance companies. These big guns can account for two-thirds of the activity in the market on a given day.
Stock prices fluctuate due to supply and demand. If a stock is in great demand, its price will rise. If it falls out of favor, there will be a lot of sellers, and the price will keep falling until it hits levels at which others will buy.
One way small investors can take advantage of big investors is to discover a small gem and invest in it early. When institutions eventually start buying (they often can’t get too involved with very small companies), they’ll drive its price up.
Q: What does it mean when a company takes a “one-time charge”? — K.W., Columbia, Mo.
A: If you read financial reports, you’ll see many companies taking “one-time” charges. These are meant to reflect costs a company is bearing that it usually doesn’t bear — such as for closing plants, downsizing or writing off bad investments. The company will often choose to remove the charge from earnings results, as if the expenses didn’t really happen, ostensibly to more accurately reflect operating performance.
Ironically, many companies report “one-time” or “extraordinary” charges fairly frequently. When this is the case, such costs probably shouldn’t be so readily dismissed.