The Evening News - Tuesday, January 07, 1997

AMERICAN MEDICAL RESPONSE <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: EMT)") else Response.Write("(NYSE: EMT)") end if %> jumped $6 3/8 higher to $39 3/8 after agreeing to merge with Canadian company LAIDLAW INC. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: LDW.A and B)") else Response.Write("(NYSE: LDW.A and B)") end if %>. American Medical is the largest ambulance service in the U.S. At $40 per share, Laidlaw picks up the company at an enterprise value of approximately $1.27 billion, or about 12.6 times annualized EBITDA (earnings before interest, taxes, depreciation, and amortization) and 1.8 times revenues (including the operations of American Medical's recently acquired Stat Healthcare services). American Medical achieved operating margins above 10%, with the Stat division's margins above 15%, and grew cash flow by 56% through the first nine months of 1996. Compare that with competitor RURAL/METRO CORP. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: RURL)") else Response.Write("(Nasdaq: RURL)") end if %>, which is valued at about the same multiples, but with smaller margins and less growth.

Home furnishings company ETHAN ALLEN INTERIORS <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ETH)") else Response.Write("(NYSE: ETH)") end if %> gained $2 5/8 to $39 5/8 after the company said Q2 results will be better than expected. First quarter earnings per share (EPS) of $0.60 beat estimates by 13%, and this quarter's estimates assumed the company would grow earnings 6.7% sequentially. A very strong quarter in housing starts has helped the company increase sales. Better margins will also contribute to what the company expects to be $0.79-0.81 EPS. Since the company owns its own mills and manufactures a good deal of its merchandise, it has flexibility in pricing and brings a larger percentage of sales down to the gross profit line. Combining tight controls over discretionary spending like marketing, the incremental sales provide the leverage needed to beat estimates and propel the shares to a new high.

NORTH FACE <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: TNFI)") else Response.Write("(Nasdaq: TNFI)") end if %> gained $7/8 to $19 3/4 today after Alex. Brown upgraded the outerwear company to "strong buy" from "buy." The shares came public earlier this summer at $14 and ran to a high of $33 before reporting apparently disappointing earnings for its third quarter ended September 30. Although gross margin contracted somewhat, the company was able to achieve an expansion of 220 basis points on operating margin (1 basis point = 1/100th of a percentage point). Earnings per share increased 11% before a charge for extinguishment of debt. The problem? Expansion in the number of shares reduced each shareholders' portion of a 62% increase in income before that charge. North Face's quality merchandise, fat margins and spring order growth make the market cap/annualized sales ratio of 1.4 look interesting.

QUICK TAKES: GILEAD SCIENCES <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: GILD)") else Response.Write("(Nasdaq: GILD)") end if %> gained $2 1/4 to $27 after the biotech company announced that it will report better-than-expected results for the year... Explosive detection equipment company VIVID TECHNOLOGIES <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: VVID)") else Response.Write("(Nasdaq: VVID)") end if %> gained $2 1/2 to $16 after a slew of brokerages upgraded the shares following the company's report of two major orders... TUESDAY MORNING <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: TUES)") else Response.Write("(Nasdaq: TUES)") end if %> was up $3 1/4 to $23 this Tuesday as the retailer reported a 24% increase in December same-store sales... Seismic data gatherer PETROLEUM GEO-SERVICES <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: PGSAY)") else Response.Write("(Nasdaq: PGSAY)") end if %> rose $2 1/4 to $42 7/8 after reporting on record productivity on its Ramform Challenger vessel... DATASCOPE <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: DSCP)") else Response.Write("(Nasdaq: DSCP)") end if %> spurted $2 5/8 to $21 3/8 after the medical devices company said it will beat Q2 estimates of $0.27 per share... Semiconductor maker RAMTRON INTERNATIONAL <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: RMTR)") else Response.Write("(Nasdaq: RMTR)") end if %> rose $7/8 to $7 5/8 after licensing its FRAM technology to Samsung... CADUS PHARMACEUTICAL <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: KDUS)") else Response.Write("(Nasdaq: KDUS)") end if %> gained $2 7/8 to $15 1/8 on announcing the extension of a research agreement with BRISTOL MYERS SQUIBB <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BMY)") else Response.Write("(NYSE: BMY)") end if %>... Biotech biggie GENZYME CORP. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: GENZ)") else Response.Write("(Nasdaq: GENZ)") end if %> gained $1 1/8 to $25 1/2 after reporting strong Q4 sales today... AXENT TECHNOLOGIES <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: AXNT)") else Response.Write("(Nasdaq: AXNT)") end if %> added $1 1/4 to $17 1/4 after the data encryption company announced the acquisition of authentication products firm AssureNet Pathways... Irish biopharm ELAN <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: ELN)") else Response.Write("(NYSE: ELN)") end if %> rose $1 1/8 to $36 1/8 after signing an agreement to market an Alzheimer's treatment owned by R.P. SHERER <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: SHR)") else Response.Write("(NYSE: SHR)") end if %>... HCC INSURANCE HOLDINGS <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: HCC)") else Response.Write("(NYSE: HCC)") end if %> gained $1 3/4 to $27 1/8 after getting the nod from analysts with a ratings upgrades following an acquisition announced yesterday... Medical device company SOFAMOR/DANEK GROUP <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: SDG)") else Response.Write("(NYSE: SDG)") end if %> rose $3 1/2 to $35 5/8 on a "buy" rating from PaineWebber... OLYMPIC FINANCIAL <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: OLM)") else Response.Write("(NYSE: OLM)") end if %> gained $2 to $17 3/8 after the auto finance company named a new chief executive officer... After receiving pre-market approval from the FDA for its MRI system, INTERMAGNETICS GENERAL <% if gsSubBrand = "aolsnapshot" then Response.Write("(AMEX: IMG)") else Response.Write("(AMEX: IMG)") end if %> gained $1 1/4 to $13 1/4.

Prototype modeling software company MECHANICAL DYNAMICS <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MDII)") else Response.Write("(Nasdaq: MDII)") end if %> cratered $4 7/8 to $8 7/8 after announcing fourth quarter sales will be hit by lower-than-expected revenues in the Asia/Pacific region as well as the stronger dollar against the yen. Sales of Japanese cars in the U.S. have not been particularly brisk this year; however, December new car sales for were up over 16% in Japan. Overall, the fortunes of Mechanical Dynamics' customers have not changed drastically. The key issue here is the sensitivity of the company's earnings to its sales levels. Reduced sales will not necessarily force the company to change its operating model mid-way through the quarter. Judging by the steep falloff in the shares and the $0.16 per share earnings estimate, margin and sales expectations were very high for the quarter.

QUICK CUTS: Tobacco and wine company UST INC. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: UST)") else Response.Write("(NYSE: UST)") end if %> fell $2 5/8 to $30 3/4 after the company said lower smokeless tobacco sales will hurt earnings... CARPENTER TECHNOLOGY CORP. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CRS)") else Response.Write("(NYSE: CRS)") end if %> lost $1 7/8 to $34 7/8 after the structural materials company said fiscal 1997 earnings will fall below 1996 results... After reporting flat Q3 earnings, direct marketing services firm AMERICAN LIST <% if gsSubBrand = "aolsnapshot" then Response.Write("(AMEX: AMZ)") else Response.Write("(AMEX: AMZ)") end if %> plunged $7 1/4 to $22 7/8... SILICON GRAPHICS <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: SGI)") else Response.Write("(NYSE: SGI)") end if %> was whacked for a $1 3/4 loss to $25 1/8 after the company announced break even quarterly results... Publishing software concern DOCUMENT SCIENCES <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: DOCX)") else Response.Write("(Nasdaq: DOCX)") end if %> was docked for a $4 1/4 loss to $5 7/8 after saying it will miss Q4 earnings estimates by four cents... NOODLE KIDOODLE <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: NKID)") else Response.Write("(Nasdaq: NKID)") end if %> lost $1 1/2 to $4 3/8 on poor same-store sales results for the holiday season... Restaurant company LONGHORN STEAKS <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: LOHO)") else Response.Write("(Nasdaq: LOHO)") end if %> was speared for a $2 3/8 loss to $16 1/4 after brokerage J.C. Bradford cuts its earnings estimates.

Why do stocks go up? As obvious as the answer seems, individual investors wrestle with this question every day. Built into every investment approach are assumptions about the factors that actually cause stocks to move in price. Technical analysts see investor psychology as a crucial ingredient, while fundamental analysts view actual facts surrounding the business as important. And then there are those who consider the current phase of the moon.

Watching a multitude of individual stocks make large percentage changes every day is one of the small benefits of working at the Fool HQ newsroom. In fact, the ultimate value of Fool News products as teaching tools is that you see dozens of stock moves explained every day. Although I have never done any systematic study of the subject, two factors clearly have a disproportionate effect on stock price -- earnings growth and the price paid for that earnings growth. Excess returns from an investment derive from the underlying growth in the earnings per share (EPS) and expansion of the company's multiple (price/earnings ratio).

If a company can grow earnings in the future at a faster rate than the overall market, over time, regardless of the price that you paid for those earnings, you are going to outperform the market. Take for instance COCA-COLA <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: KO)") else Response.Write("(NYSE: KO)") end if %>. When Warren Buffett plowed one-quarter of the assets of BERKSHIRE HATHAWAY <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BRK)") else Response.Write("(NYSE: BRK)") end if %> into Coke in 1989, many in the financial press called it Buffett's Folly. Paying 15 times trailing earnings for a company in a market that was going for an average of 11 times earnings seemed an incredible premium to pay. However, in Buffett's corner was the value of compounding. If Coca-Cola could maintain its business model and generate 15% to 20% annualized EPS growth, the underlying earnings growth alone would make the stock a huge winner.

COCA COLA'S HISTORICAL EARNINGS

Fiscal Year          Earnings Per Share
      '91                        $0.61
      '92                        $0.72 
      '93                        $0.84 
      '94                        $0.99 
      '95                        $1.17

An investor who paid 15 times earnings for Coca-Cola after the fourth quarter of fiscal 1991 was reported would have paid $9.15 per share. Given that Coca-Cola represented a fairly straightforward and stable business model and was plowing free-cash flow into stock repurchases, at this point envisioning 15% to 20% annualized growth was not entirely outside of the realm of possibility. An investor in 1991 could have handicapped profits at the end of fiscal 1995, assuming that they would come in around $1.16 EPS, or 17.55% annualized growth. Four years later, at the end of fiscal 1995, Coca-Cola reported $1.17 EPS. Even if Coca-Cola had simply stayed at 15 times earnings, the investor would have enjoyed 17.5% stock appreciation as the underlying base of earnings increased.

This effect can serve to make investors money even if the multiple drops. Say you paid 25 times earnings in 1991, or $15.25. The day after, pretend Coke dropped to only 15 times earnings. Four years later, 15 times earnings of $1.17 EPS would be $29.25, an increase of 3.6% a year -- a pretty lousy investment. However, let's go out to 1999 and assume four more years of 17.5% earnings growth. This gives us $2.23 EPS in earnings and puts Coca-Cola at $33.45, or 10.3% per year. If we push out the time period further, the number will go higher. Why is this? Because over long periods of time, stock appreciation and earnings growth converge if the multiple to earnings stays constant.

Of course, everyone knows that multiples are hardly constant. This is why high price/earnings ratio stocks cause such consternation for many investors -- if the multiple being paid for earnings goes down, it could take years of earnings growth to catch up to the level the stock was at when it was purchased. This is where the second main component of excess returns in stock investing comes into play -- multiple change. Although many investors are willing to invest in companies that can grow earnings at above market rates, confident that the returns and the earnings growth will converge, another class of investor worries about the price paid.

High earnings growth combined with a significant increase in stock multiple is the stuff ten-baggers (investments that increase ten-fold) are made of. If you can buy a Coca-Cola at 15 times earnings, see it grow earnings at 17.5%, and on top of that see the multiple go up to 30, that makes for some pretty compelling returns. The earnings growth alone would result in returns of roughly 100%. The multiple change alone would result in returns of 100%. The combination of the two makes for returns of 400%. Does this happen very often? Off of the top of my head I can cite DELL COMPUTER <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: DELL)") else Response.Write("(Nasdaq: DELL)") end if %>, INTEL CORP. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: INTC)") else Response.Write("(Nasdaq: INTC)") end if %> and WESTERN DIGITAL <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: WDC)") else Response.Write("(NYSE: WDC)") end if %> as three companies that have increased earnings and multiple over the past twelve months, resulting in stock prices that have doubled, tripled and, in the case of Dell, quadrupled from their lows.

The importance of perceived future earnings cannot be underestimated when considering day to day price movements. Burton Malkiel and the random walk aside, when stocks get killed on a specific day, the majority of the time it is because earnings will not live up to expectations. This causes a double whammy as the multiple normally decreases as a result of less perceived future growth. The multiple paid for earnings is very important as well, as any positive changes in the multiple magnify your upside. The ideal stock? A company that can generate above average earnings growth that is currently selling at a below average price/earnings ratio -- the kind of stock that you can often find with something like the PEG ratio.

SHIVA CORP. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: SHVA)") else Response.Write("(Nasdaq: SHVA)") end if %>
avail 1/7 from 6-10 PM EST & 1/8 from 5-10 AM EST
(800) 458-7879 (access code: 52720)

TENET HEALTH CARE <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: THC)") else Response.Write("(NYSE: THC)") end if %>
available until Friday, 1/10
(402) 220-1008

Learn to value stocks painlessly! In the Industry Decathlon primer, MF Bogey takes readers by the hand and walks them through five stock valuation methods and ten financial ratios, demonstrating how to compare a bunch of companies in your industry of choice and find the most promising one. This is very useful stuff, folks! Check it out at keyword: FoolMart on America Online or at our website (). You might also be interested in his weekly Industry Decathlon report, delivered by e-mail or fax. In it, Bogey examines a different industry each week and runs its top players through his decathlon to discover which one company looks the most attractive.

Randy Befumo (MF Templar), a Fool
Fool On the Hill

Dale Wettlaufer (MF Raleigh), another Fool
Heroes & Goats

Brian Bauer (MF Hoops), one more Fool
Editing