8X8 Inc (EGHT) has experienced a year of aggressive growth with the stock price increasing nearly 86% this year. This movement in price has added over $200 million in shareholder value to the firm, and through this analysis, I present my belief that further upside is entirely likely.
Returns are Key
When a firm grows very rapidly in terms of share price, investors should attempt to isolate the cause or driver of price change. Frequently, shares are driven by speculation or investor euphoria; however, on occasion, tangible, fundamental performance lies behind a run-up in price.
EGHT has demonstrated, through its return on assets and return on equity, that it is experiencing fundamental growth. Return on assets is a ratio that divides the profit of the firm by the assets utilized to generate profits and it tells an investor how effectively a firm is using its tangibles to produce value.
Return on equity is a ratio that is calculated as net income divided by directly invested shareholder equity and the figure tells researchers how well management uses investments to generate profit.
Click to enlarge
The chart above shows nine years of return on asset and return on equity data for EGHT. The first thing that investors should notice is that for the past nine years, 8x8 has consistently performed better in each of these metrics.
Until 2008, return on assets and return on equity were negative. This means that between 2003 and 2008, the firm consistently lost money; however, it is important to note that as time progressed, EGHT was able to slow its losses. The firm began earning a profit in 2009 and ever since, it has consistently grown its asset utilization effectiveness and shareholder investment returns.
A firm that demonstrates a steady, and growing, history of returns is one that may warrant an investment. We should not blindly invest in any firm that has a history of returns, however. In order to better position ourselves in a security, we should examine if it has a growing profit margin.
Profit margin is a ratio that basically tells the researcher the percentage of every dollar of revenue that is transcribed into profit. As profit margin increases, it means that a firm is becoming better at defending its competitive edge and is able to translate this edge into bottom-line performance.
The above chart shows five years of profit margin for EGHT. As previously mentioned, the firm was not consistently profitable until early 2009. Since then, however, the firm has been able to maintain its profitable edge and in the most recent quarter, profit margin increased by 20%. This increase in margin indicates that the trend of profitability established in 2009 is not only likely to remain, but also strengthen as time progresses.
A firm that demonstrates excellent returns that are growing and a strengthening profit margin represent a fundamentally sound organization. From both a return and margin standpoint, it is evident that EGHT is demonstrating the competitive edge necessary to not only rival competition, but also to thrive in this difficult business environment.
Many individuals get caught up in the news of an organization or current product development, but I believe that the past is a good guide to the future and by studying the historic strengths and weaknesses of an organization from a balance-sheet perspective, we can best position ourselves to make intelligent investment decisions. For this reason, I view EGHT has a fundamentally sound stock.
Even if a firm has an excellent history of returns and successfully defends its lead against competitors, we should not blindly purchase the stock. In order to best time our investments, we should utilize simple technical reasoning as to when to enter a position. EGHT has had a powerful year and if we were to blindly purchase the security today, we could potentially be exposed to a downdraft in prices, as the market consolidates or early investors bank some profits.
The technical definition of an uptrend is higher highs and higher lows as time progresses. If we believe that prices are going higher, then we should only purchase when the stock has made a new high, because by definition, the trend will have resumed. This said, I believe the best time to enter the stock is if the price is able to overcome $6.50 per share. By waiting for this price level, we position ourselves to enter into the beginning of a resumption of the stock trend that has propelled prices for the past three years.
EGHT has a violent history of pullbacks in share price and by waiting for a new stage of uptrend to form, we can better protect ourselves from price uncertainty. Not only do we need an entry point into a security, but we also need to establish clear thresholds that will invalidate the timing of our research or tell us when to exit the security.
Due to historic areas of consolidation, I believe that if the price falls below $4.70 per share, then investors should exit all shares of EGHT and I will consider this analysis to be ill-timed. Additionally, for any investors who delay purchase until the price overcomes $6.50 per share, I believe that a stop-loss on this trade should be around $5.50. If the price falls below $5.50, the price will have technically ended its uptrend and will be in a period of sideways consolidation.