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How the numbers add up to a growing stock

At a time when the stock market is sending out mixed signals, how do you tell if a stock is really on the rise? This Canadian advisory tells us.

Is this anytime to be talking about growing stocks? Should investors still be holding the fort with “defensive” stocks — or no stocks at all?

Yes, the TSX has been rallying its brains out (perhaps literally). But is this the real thing, or is it just a great big sucker rally that’s going to collapse in a heap? (We talked about sucker rallies yesterday.)

In fact, you should always be looking for growing stocks.

And if can look past the current gyrations of the stock market toward a calmer future, you should be looking for growth that has some staying power.

That’s the opinion of one of Canada’s most venerable stock advisories, The Investment Reporter.

Of course, the credit crisis, the resulting market mayhem and a contracting economy have made many perfectly good stocks look like they are shrinking, not growing.

The trick is to look at a company’s interior growth, to identify stocks whose business is growing and whose share prices will catch up in time.

And there’s an easy way to do it, says this advisory.

Wear and tear

Go to the income statement, says the advisory, and add up the numbers. (The easiest way to do this, if you don’t already own the stock and get the company’s reports, is to go to the company’s own web site under Investor Relations.)

The advisory chooses a specific income statement, the first-quarter report of Shoppers Drug Mart (TSX-SC), a stock it covers regularly.

The first number is right near the top under Operating Expenses. It is regular depreciation and amortization. This will indicate the “wear and tear on the company’s assets as it carries on business.” It does not include any one-time writedown of goodwill, intangible or obsolete assets.

In Shoppers’ case, first-quarter amortization came to $55.6 million.

Growing, not shrinking

Next comes “investing activities” (under Consolidated Statements of Cash Flows). Here you find capital investment. Companies often sell assets such as plants, property, equipment, land or buildings. Subtract the proceeds of the sales from capital spending and you get the company’s net capital spending.

Shoppers spent $81.2 million on property and equipment and sold $5.2 million worth of the same. So capital spending was $76 million.

Now put the two together, says The Investment Reporter. “When depreciation and amortization is less than net capital spending, the company is growing.” Capital spending topped amortization by $21 million.

So this company grew in the first quarter. But there’s more.

Buying assets

Look at acquisitions, says the advisory. It’s just like capital spending. Buying assets is the alternative to building them. “It can also speed the company’s entry into a new field of operations.”

In the first quarter, Shoppers bought $27.3 million worth of pharmacies. This adds to its size and market share, of course.

But take the long-term view as well, says the advisory. A new project or new acquisitions may cause spending totals to bounce around from one quarter to the next. So it’s best to compare over a period of years.

“One useful starting point,” says the advisory, “is when the chief executive officer first assumed his job.” In other words, is a project his or somebody else’s? Will he stick with it or switch horses?

Now for the big figure, cash flow.

Raise your dividends

Look at the total cash flow from operating activities, says this advisory. (Eliminate the net change in non-cash working capital, since this can distort the results for the specific quarter.)

The total for Shoppers is $163.3 million.

From this, subtract the amount going to capital spending, dividend payments and acquisitions. We already know that capital spending added up to $76 million and acquisitions to $27.3 million. Dividends (they’re under Liabilities in Consolidated Balance Sheets) came to $46.7 million.

The spending comes to $150 million. So the cash flow covers it with plenty to spare.

This means that the company can afford to keep expanding. And it should be able to limit debt to reasonable levels. And one more thing.

“This suggests that the company will continue to grow and raise your dividends every year.”

The Investment Reporter sums up. Seek out companies whose capital spending and acquisitions regularly exceed their deprecation and amortization. And look for companies that have the cash to fund their growth and pay their dividends without running into heavy debt.

These are just some of the clues you need to pick a stock, but they’re very important clues.

They will tell you whether or not a company is growing. And you don’t have to take anybody’s word for it. You have the figures right in front of you. Your analysis is as sound as anyone else’s.