How The EPS Rating Homes In On Superior Profits In The Stock Market

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A hot product or website may send a company’s stock on a tear, but it won’t be able to sustain that advance unless potential turns into profit.

It’s a risky proposition to speculate on which young companies will be able to emerge from the red and achieve success, and which will get squeezed by competition and fail.

It’s also not a game you have to play to excel in the stock market. Over the long run, the best companies in which to buy shares are those that generate the fastest, most consistent earnings growth. Those stocks typically see their most impressive gains after their track record for solid earnings power has already been established.

IBD simplifies your search for stocks with superior earnings growth by using a proprietary Earnings Per Share Rating, provided each day for most stocks. The rating takes into account a company’s annual earnings growth over the past three to five years, giving emphasis to the most recent two quarters.

IBD’S TAKE: Find the EPS Rating by going to IBD Stock Checkup, which also displays the Relative Price Strength Rating, Accumulation/Distribution Rating, SMR (Sales + Margins + ROE) and Composite Rating to get a full picture of any stock’s individual potential, as well as how it matches up with peers in the same industry.

Most companies with strong earnings growth will carry EPS ratings of at least 80, meaning their earnings record has outperformed 80% of all stocks.

A high EPS rating doesn’t necessarily mean a company’s stock will perform well, but it’s an important element to consider when deciding which stocks may be good investments.

ICch_qlgc_072816IBD’s study of the greatest winning stocks shows the best have had an average EPS rating of 93 before making their major price advances.

Consider QLogic (QLGC), a maker of networking products that provide high-performance connections between computer systems and data-storage peripherals. Shares of the Southern California-based company rocketed 146% from January to August 1999, and it’s no mystery why.

Just look at QLogic’s earnings growth rate over the previous five quarters. For the quarter ended June 1998, the company earned a split-adjusted 13 cents a share, up 44% from earnings in the June 1997 quarter. Profit in the September 1998 quarter increased 70% from the year-earlier period.

And the year-over-year quarterly earnings growth continued to accelerate, increasing 73%, 92% and 131% in the trailing three quarters, respectively.

On an annual basis, the company’s earnings increased 700% in the fiscal year ended March 1997 from a small profit the prior year. Earnings grew 75% in fiscal 1998 and 71% in fiscal 1999. The result was a three-year growth rate running at 89%.

Those profits added up to a 99 EPS Rating, better than 99% of all other public companies in IBD’s database.

As QLogic’s earnings growth accelerated, its EPS Rating improved. A year earlier in 1998, its EPS was around 70, but by early May it carried a 98 EPS, a definite candidate for further consideration.

From mid-January through early May of 1999, the stock consolidated its gains. But after the company blew away earnings forecasts by 5 cents a share for its March quarter, the stock took off, soaring more than 18% in a single session on May 7, and breaking out past a 79.85 cup-with-handle buy point to a new high (the accompanying chart includes stock splits).

By that time, there was little doubt about the company’s ability to generate strong earnings growth, and the stock was ready for a powerful advance. By August, the stock ran up another 79%.

The moral of the story: Don’t disregard the importance of strong earnings growth. You’re better off focusing on companies that have grown profits at least 20% to 25% over the past three years and continue to show solid, even accelerating, quarterly growth.

(Editor’s Note: This column originally published in the Aug. 25, 1999, edition of IBD.)