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Lessons for Investors

Not all firms that report stable earnings are good investments. At the minimum, you need to consider whether these firms offer any growth potential, whether earnings stability translates into price stability and finally, whether the market is pricing these stocks correctly. It is no bargain to buy a stock with stable earnings, low or no growth, substantial price volatility and a high price-earnings ratio. Reverting to the sample of all firms in the United States, the following screens were used:

  • The coefficient of variation in earnings per share has to be in the bottom 10% of the overall sample. You can use alternative measures of earnings stability to make this judgment, still the argument for using earnings per share rather than net income or operating income were presented earlier in the chapter. You can also add on additional screens such as the requirement that earnings have increased every year for the last few years.

  • The beta of the stock has to be less than 1.25, and the standard deviation in stock prices over the last three years has to be less than 60%. While it is unlikely that many stable earnings companies will be high risk, there will be some companies for which prices remain volatile even as earnings are stable. The risk screens will eliminate these firms.

  • The price-earnings ratio has to be less than 15. Buying a great company at too high a price is no bargain. Consequently, you need to make sure that you are not paying a premium for earnings stability that is not justified.

  • The expected growth rate in earnings per share over the next five years has to be 10% or higher. Earnings growth is always a bonus. A company with stable and growing earnings is clearly a better investment than one with stable and stagnant earnings.


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