Major tech stocks have rallied on the promise of generative AI. But how can we tell if they are not just in a huge bubble?
IBD's stock picking methodology tells investors how to spot true growth leaders. A central piece of this methodology is superior earnings per share (EPS) growth.
EPS is calculated by dividing a company's total after-tax profits by the total number of shares outstanding. The latest EPS can be found in the stock quotes at Investors.com.
In "How to Make Money in Stocks," IBD founder William O'Neil observed that true market leaders "show a major percentage increase in current quarterly earnings per share (the most recently reported quarter) when compared to the prior year's same quarter."
But there are a few important things to remember.
Investors are better off comparing earnings with the same prior year's quarter to make sure they are comparing apples to apples.
A minimum of 25% earnings growth is a good rule to follow. That is because a company that is just eking profits and reporting low earnings growth may quickly reverse into a loss. Earnings increases above 40% are even more preferable.
Context is also important. A single earnings spike is not enough to go by. Investors need to ask if the earnings growth will be sustained. Look for minimum 25% EPS growth over the two most recent quarters to indicate the company is on a steady profit path.
It is a good idea to check for sales growth as well. Ideally, both sales and earnings growth should top 25% in the most recent quarter. Lower sales with strong earnings growth could indicate some trouble that is not showing up in the bottom line.
ServiceNow's Profit Record
Annual EPS growth is also an important way to identify sustainable growth stocks. IBD recommends looking for annual earnings growth of at least 25% in the past three years as well as the two most recent quarters.
The Earnings Stability Factor in IBD MarketSmith is also a good tool to use. The lower the earnings stability number, the more stable the company's earnings performance.
Beware of decelerating earnings growth as well. If a company posts 50% earnings growth and 25% the next quarter, investors should check whether the slowdown is a trend or just a one-off event.
Leading workflow automation stock and AI play ServiceNow started an earnings rebound when it reported third-quarter EPS growth of 26% year over year on Oct. 27,2022 (1).
The next quarter, EPS jumped 56% (2) then 37% in first quarter of 2023 (3). The stock broke out May 17 from a cup with handle base with a buy point of 485.58 (4). Annual earnings were also outstanding, increasing from $5.92 per share in 2021 to $7.59 in 2022. The stock climbed more than 26% until it started its next base in July.
Another stock in the enterprise software group, Salesforce, posted an EPS gain of 100% just before the stock broke out of a cup with handle at 178.84 on March 1, 2023.
This article was originally published Dec. 8, 2023, and has been updated. Please follow VRamakrishnan on X/Twitter for more news on the stock market today.
