The Earnings Power 10-Minute Test

There are myriad ways to make money on Wall Street, just as there are many ways to lose money in the stock market. Here are some venerable strategies:

Net current assets

Graham & Dodd (e.g., low price-to-sales, price-to-earnings or price-to-book)

Sum-of-the-parts

Turnaround

Spin-off

Cyclical

Short-selling

Merger arbitrage

Operating leverage

Earnings power

As readers of this column know, my primary interest is with the last item on the list -- earnings-power companies. According to conventional wisdom, an earnings-power company keeps making more and more money every year. In theory, if you buy and hold a business of this ilk long enough, you'll make big bucks.

Using a Screen

I want to own the Next Big Thing, just like you. But I reject this earnings-centric notion. That's because the income statement found in the annual report, 10-K and 10-Q has four substantive limitations. As a result, you risk owning a seemingly profitable company like WorldCom or Enron that suddenly goes poof.

Instead, I gauge the quality of a firm's accrual profits using a defensive and enterprising income statement. This two-dimensional model is almost always a better leading indicator of stock prices, especially stock prices of companies headed for the shoals.

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The shortcoming of this approach is the time it takes to print all the Securities and Exchange Commission filings and enter the data into my spreadsheet. There's more to life than the stock market.

To squeeze the most out of my workday, I screen earnings-power candidates with a few easy calculations. Perhaps you will want to use this protocol too.

Performance Hunt

As an example, let's look at Performance Foods (PFGC - commentary - Cramer's Take), a Richmond, Va., distributor of food and other products to restaurants, hotels, cafeterias, schools, health care facilities and other institutional customers. The company has $3.2 billion in revenue, and you will benefit from having a copy of the firm's 2001 financials in front of you.

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Hewitt Heiserman has been a financial analyst for 15 years and has worked for Fidelity Investments, Simplex Time Recorder, American Holdco and Breakaway Solutions. He is now writing a book on the Earnings Power Box, an analytical model he created to gauge the quality of a firm's profits. (The Earnings Power Box is a trademark of Hewitt Heiserman.) At the time of publication, Heiserman had no positions in any of the securities mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback and invites you to send it to [e-mail].