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Earnings matter—because earnings drive stock prices. Identify the right qualities in a high-growth stock, and you’ll have the best chance of finding stocks that I call “Earnings Busters.”

It’s given that Earnings Busters have good projected earnings growth, and it’s a plus, though not imperative, that they have good historical earnings growth. After all, a company might be just starting a growth cycle.

Once you have list of Earnings Busters candidates—and there’s an unlimited supply of those on financial websites—you need to compare the earnings qualities of those candidates to select the ones you want to buy.

My number one rule is to have a system for doing this, so that my emotions don’t become part of the equation. In Part I of this article I gave the three basic rules of my system for finding Earnings Busters:

  • Make sure the stock is not priced too high for its earnings growth rates.
  • Make sure the company growth ratio (CGR) is reasonable.
  • Make sure the company has conservative (or at least not overly aggressive) accounting and governance policies.

Let’s take a closer look each of these rules.

Rule #1. Don’t pay too much for earnings growth. A stock’s price-to-earnings (P/E) ratios tell you how much you are paying for the company’s earnings.

The current P/E reveals how much you’re paying for current earnings. It is the current stock price divided by current earnings (or estimated earnings for this year, if you’re in the middle of the company’s fiscal year). A current P/E of 10 means you’re paying 10 times the current earnings.

If the current P/E is too high compared to the stock’s current earnings growth rate, there is less room for the stock price to grow, so you could be paying too much.

How high is too high? Ideally, the current P/E should not be greater than the current year’s earnings growth. Take a stock with a projected earnings growth rate of 20% for 2011. A current P/E is 20 would be fine. A current P/E of 10 would be excellent. A current P/E of 30, however, would make me uncomfortable, as I’d be paying 30 times current earnings. And if the company failed to make those earnings the stock price would have further to fall.

The forward or projected P/E—which is the current stock price divided by next year’s projected earnings— tells you what you’re paying for future earnings. It is even more important than the current P/E because current earnings are more likely to be already taken into account by the market.

A similar how-high-is-too-high rule applies to the forward P/E. I would like it to be no higher than next year’s projected earnings growth rate. In general, a stock with a 20% projected earnings growth rate for next year would need a forward P/E of 20 to be an acceptable candidate.

Where to find P/E ratios and earnings growth rates. P/E ratios and earnings growth rates can be found at many financial websites. I favor Yahoo Finance and CNBC. At finance.yahoo.com, enter the stock ticker and on the left menu click Key Statistics for the P/E ratios and Analyst Estimates for the current, next, and 5-year earnings growth rates). At cnbc.com, enter the stock ticker and click the Earnings tab for P/Es and earnings growth rates.

Rule #2. Look for a reasonable company growth ratio (CGR). The company growth ratio is the annualized 5-year projected growth rate divided by the forward P/E ratio. It offers a longer-term view of the company’s earnings growth prospects. For example, a company with a projected 5-year annual growth rate of 30% and a forward P/E of 12 would have a CGR of 2.5 which is excellent.

Any number over 1.0 is an acceptable CGR, but anything lower than 1.0 would raise a red flag for me. Why? Because the CGR compares a company’s long-term growth prospects—specifically, 5 years from now—to its current price (remember, the forward P/E is the current stock price divided by next year’s earnings estimates). Five years is a long time in “market-years.” If the company fails to meet earnings estimates, the lower earnings will raise the P/E, which will probably cause the stock price to fall and will likely cause analysts to revise their future estimates. This would impact the CGR and provide additional impetus to the falling stock price. Not exactly the goal of an Earnings Busters portfolio.

Where to find the CGR: A company’s CGR is not readily available, but it’s easy to calculate. Divide the estimated annual 5-year growth rate by the forward P/E ratio, both available at Yahoo Finance.

Rule #3. Don’t ignore a company’s accounting and governance methods. Accounting and governance practices relate to a company’s corporate integrity. If these practices are rated as aggressive, I would think twice about buying the stock. There’s too big a chance that such a company might run afoul of the Securities and Exchange Commission (SEC). At a minimum, the company might have to restate its financials, which could damage its stock. At worst, fraud charges could ensue, which could not only torpedo the stock but might sink the whole company. Think Enron, AIG, WorldCom and others.

Where to find accounting and governance scores: Risk Metrics publishes a “Governance Risk Indictor” (GRI®)[1] through Yahoo Finance. You can find this on the stock’s Profile page.

Audit Integrity (AI) also quantifies risks rrrelated to a company’s accounting and governance risk and issues a risk rating called the AGR® score[2]. This is a percentile score ranging from 0 to 100, with corresponding ratings from Very Aggressive to Conservative.

In selecting the Earnings Busters, I depended on the AGR score, which Sabrient uses in its rankings. However, Audit Integrity was recently merged with GovernanceMetrics International, and the AGR scores are now available only through subscriptions.

Here are 5 More Earnings Busters to Trade Now

NOTE: All prices, ratios and earnings data are current as of May 26, 2011.

1. Delphi Financial Group, Inc. (DFG) ($28.52)

Delphi Financial Group, Inc. is a holding company whose subsidiaries—Reliance Standard Life Insurance Company, Safety National, and Matrix Absence Management, Inc.—offer integrated employee benefit services.

Why DFG is an Earnings Buster: DFG has modest earnings growth expectations for 2011 (+5.7%), but it is expected to grow at +10% per year for the next five years. Moreover, the company had positive earnings surprises in every quarter of 2010, beating 4th quarter estimates by +11.6%. The current P.E is 8.9, and the forward P/E drops to 7.3. The company has a respectable CGR of 1.7 and is rated as conservative for its accounting and governance practices. Sabrient rates DFG a Strong Buy.

2. Brigham Exploration Co. (BEXP) ($30.77)

Brigham Exploration Company is an independent exploration, development, and production company located in Austin, Texas. Its current focus is on the oil shale fields in North Dakota, primarily the Williston Basin’s Bakken formation.

Why BEXP is an Earnings Buster: For starters, Brigham is in the Energy Sector which has been one of the top-performing sectors in the past weeks because of the ongoing crises in the Middle East. That aside, its estimated earnings growth rate for 2011 is +132% with an expected growth rate of +40.8% per year over the next five years. While the current P/E is very high at 108, the forward P/E ratio is only 13. Considering the earnings growth rates, it has an excellent CGR of 3.04. All this overcomes its slightly aggressive rating for accounting and governance practices. Sabrient rates BEXP a Strong Buy.

3. Arch Coal, Inc. (ACI) ($29.46)

Coal demand for power generation and steel production continues to accelerate with the growth of emerging nations like China and India. The coal industry is further boosted by the nuclear meltdown threats in Japan. Arch Coal is one of the world’s largest coal producers. In early May it announced plans to acquire International Coal Group (ICO) for $3.4 billion, or $14.60 per share. An ACI shareholder apparently doesn’t think that’s high enough and has brought suit against the company, but with or without the acquisition, ACI has outstanding credentials as an Earnings Buster.

Why ACI is an Earnings Buster: ACI earnings are expected to grow +123% in 2011, +55% in 2012, and +99% per year for the next five years. The current P/E is 22, not even high considering the growth rate, but the forward P/E drops all the way to 7.5. The extraordinary earnings growth rates give the company a phenomenal CGR of 13.2. ACI’s accounting and governance practices are rated average. Although the stock is rated a Hold by Sabrient, it is likely because of the pending acquisition. As I stated previously, ACI can stand on its own as an Earnings Buster.

4. Baidu, Inc. (BIDU) ($129.95)

Included in the Nasdaq-100 Index, Baidu is a Chinese search engine, something like a combination of Google and Wikipedia, except with content censored in accordance with the Chinese government. The real Wikipedia states that Baidu has a market share of 56.6% of the 4.02 billion search queries in China in the fourth quarter of 2010.

Why BIDU is an Earnings Buster: Baidu’s earnings are expected to grow at +72.5% in 2011. The current P/E of 71 is high, but the forward P/E is 32. That may still seem high, but considering the projected earnings growth rate of +55% per year over the next 5 years, it is more than acceptable. The company has a CGR of 1.70, and its accounting and governance practices are rated conservative. Sabrient rates BIDU as a Strong Buy.

5. Arrow Electronics, Inc. (ARW) ($43.43)

A Fortune 500 company, ARW provides electronic components and enterprise computing solutions through a global network of more than 340 locations in 52 countries and territories.

Why ARW is an Earnings Buster: Arrow’s 2011 earnings are expected to increase +30% from last year and to grow at a rate of +15.4% per year for the next 5 years. What’s more, the earnings are cheap—the current P/E is 9.7 and the projected P/E, only 7.5. Arrow’s CGR is a healthy 2.05, and its accounting and governance practices are rated low risk by Risk Metrics. Sabrient’s earnings quality ranks a bit below average, but the growth metrics make that risk tolerable. ARW is rated a Buy by Sabrient.

The success of Earnings Busters depends on selecting stocks with the very best combination of growth prospects, favorable valuation, and conservative governance and accounting practices. You can weight the three factors equally or give more weight to the ones that are most important to you. I tend to rank prospective growth the highest, with valuation a close second, and governance and accounting practices a close third.


[1] GRI is a registered trademark of Risk Metrics.

[2] AGR is a registered copyright of Audit Integrity, Inc.

Source: 5 Earnings Busters to Trade Now, Part II