How To Buy Stocks: SMR Rating Examines Factors That Drive Profits

IBD’s SMR Rating is a set of three financial gauges that help investors understand a company’s future performance based on past metrics, namely the ones that influence profitability.

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Earnings are a powerful indicator, but what drives earnings growth? The answer does not lie in profits or sales alone but rather in a combination of several indicators. The SMR Rating tries to look at what the company has done, is doing, and will probably continue to do.

IBD’s SMR Rating is a combination of sales three gauges, profit margins, and return on equity (ROE). The rating goes from A to E, with A being the best and E the lowest.

Three Key Indicators Of Profit Quality

The S stands for sales growth. Sales increases of at least 25% in the most recent quarters and for the current year set apart leading stocks, based on studies of market winners.

The M stands for profit margins. Investors should look at both pretax annual margins and after-tax quarterly margins when assessing a company’s profitability. Ideally, both should be near the top of the recent quarters and for their industry.

Return on equity, the R in the rating’s acronym, is the way investors can tell how well a company is executing its business plan and using its capital. Return on equity is a simple division of net income by shareholders’ equity. ROE of 17% or higher is a good indication of a company’s ability to profitably use shareholders’ money.

The SMR Rating has helped identify many winning stocks.  Take IBD 50 stock Enphase Energy (ENPH).

The renewable energy company’s sales have grown 46% to 97% the past four quarters, according to IBD MarketSmith. Enphase’s return on equity has been higher than other stocks in the renewable energy sector, an outstanding 74% in the latest fiscal year.

Pretax profit margin was 25.1% in the last fiscal year, a figure that can be found in the stock quote for Enphase.

Enphase broke out of a double-bottom base June 2. At the time, its SMR Rating was an A. After its earnings report on July 26, the stock rose nearly 40% to new highs. Today, it still has an A SMR Rating.

You can find the SMR Rating on IBD Stock Checkup and on the proprietary chart analysis tool IBD MarketSmith.

Exceptions, Other Factors To Consider

The SMR Rating should be used in tandem with other factors such as the sector outlook, macroeconomic outlook and other factors that may affect corporate profits during a quarter or a year.

Exceptions to the rule should also be kept in mind. There is not enough data to judge a company that has just gone public. So a company with a poor SMR Rating may turn around and become very successful, and vice versa.

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