4 EVALUATING RISK and REWARD over
the next 5 years
Section 4 answers the question "Is this stock a buy today?
Section 4A: High Price - Next 5 Years
Determining the Forecast High Price:
Toolkit (financial software) determines the "Forecast High Price" by taking the "average high P/E" from Section 3, Column D, Row 7 (referred to as 3D7) and multiplying this number by the "Estimated High EPS." Don't automatically take the "average high P/E" and move it down to 4A. Toolkit does this but you don't have to accept it. You need to look at the numbers in Section 3D7 and ask does it make sense. If the "high P/E's" have been decreasing over the past few years, the average of five years will be too high. You may need to lower the average high P/E. You will need to use your own best estimate as to what average high P/E should be used in calculating the potential high price.
Toolkit takes your "Estimated Future Earnings Per Share Growth" from your projection at the bottom of the first side of the SSG and puts it into 4A as a dollar figure (not a percent). You may need to change this "Estimated High EPS" from what Toolkit automatically puts in here. Click on the yellow box "Estimated High EPS" and you will see at the bottom of the screen Estimated Earnings Per Share: Preferred Procedure Calculation. There are three choices:
a. EPS Preferred Procedure
b. Projected EPS
c. Other. You may enter another figure under Other for Earnings Per Share based on your judgment. This section provides further information on what the analysts predict as noted on Value Line or whatever source you use for entering figures into the Toolkit database. Rule of Thumb - analysts on Value Line are always optimistic. Thus, the values may be projected higher than will actually be realized by the company.
If you are a novice, it is recommended that you skip the Preferred Procedure. However, as a novice, you can use the Preferred Procedure as a "second opinion" as to what future earnings might be.
Determining if the
High Price is Realistic:
To determine if the "Forecast High Price" (referred to as 4A1) is too high or too low, compare it to the projected high price listed on Value Line. This projected high price is listed in the upper left side of Value Line in the section titled "2005-2007 PROJECTIONS. There is a High and a Low price. For example, the 2005-2007 Projections might list a high of $75 and a low of $35. The High price is the projected high of the high price and the Low price is the projected low of the high price. Think about it as a range of high prices. For example, the projected high of the high price is $75.00 and the projected low of the high price is $35.00. Compare your forecast high price in Section 4A1 to the high of the high and the low of the high prices in Value Line.
In order to align your "Forecast High Price" closer to the low of the high price range on Value Line, you may need to lower the "Average High P/E" or lower the "Estimated High EPS" in 4A until you achieve a forecast high price that is reasonable.
Lowering the "Average High P/E" is not just trying to make the numbers come out the way you want them to. P/E's were extremely high at the turn of the century and into the early 2000 years. To use the most recent five-year average may not be conservative enough. History has shown that there will be a correction, and prices will come back down to produce more rational and lower P/Es.
Section 4B: Low Price - Next 5 Years
Determining the Low Price:
Low price for the next five years is the low price anytime during the next five years, even the next quarter. Determining the low price is even more important than determining the high price. This is one of the most critical numbers in the entire SSG. If you don't set your low price low enough, your price zones in Section 4C Zoning will be skewed too high, and you may buy a stock at too high a price and be unable to double your money in five years.
Section 4B has four parts 4B (a), (b), (c), (d). Line 4B (a) is discussed in the next paragraph and is the line on which to focus in the study of growth stocks. Lines (b), (c), and (d) create three low prices that are used for determining cyclical stocks, turnaround situations, and dividend-producing stocks. These last three will not be discussed here because studying cyclical and turnaround situations requires additional input of data outside of the SSG. It involves timing as well as how the company fits into the business cycle, what management is doing to repair existing problems, and determining if the company can repair itself.
4B (a) Average Low P/E.
The low price for the next 5 years takes the "average low P/E" (referred as 3E7) times the "estimated low EPS." You can change the numbers in the green and yellow boxes in Toolkit. If the "average low P/E" (3E7) is not low enough, the estimated low price (referred to as 4B1) will not be low enough. You may need to remove any outliers in Section 3, Column E so that a more realistic low P/E is obtained. Once outliers have been eliminated in Section 3, the average low P/E still may need to be adjusted lower in order to get a more realistic low price (4B1).
Determining if Your
Low Price is Realistic:
There are numerous ways to assess whether your low price in 4B1 is realistic or not.
1. Check Value Line (the top of Value Line lists the high and low prices for each year) or Section 3, Column B (referred to as 3B) for the low price of the stock for the past 5 years. Is your forecast low price similar to the average low prices for the previous 5 years? (In 3B7 the average low price of the most recent five-year history is given.) If not, you may need to readjust it. It is critical to set the low price as realistically low as possible.
2. Use one of the choices that Toolkit provides by clicking on the estimated low price green box (4B1). Toolkit provides you with four choices to set the low price.
3. Bob Adams of BetterInvesting also recommends that another way to determine the low price is to look at the price bars for the past 5 years on the front side of the SSG. The year with the longest bar will be the most volatile year for high and low prices. Now go to the back page of the SSG and look at that year in Section 3. For example, if the year with the longest price bar (most volatile year) was year 2000 and the high price was $20.00 and the low price was $10.30, then the ratio between the high and low price is 0.52 ($10.30 divided by $20.00 equals $0.52). Now take that ratio that represents the most volatile year in the past 5 years and multiply it times the current 52 week high. For example, if the current 52-week high is $21.00, then 0.52 times $21.00 equals $10.90. This would be your projected low price.
4. Another method is called the Price Variant Quotient (PVQ). The steps for determining the PVQ are listed below with an example given at the end:
a. Find the five year average for each of the high and low
b. Subtract the low price from the high price to get the difference.
c. Divide this number by the high price to get a decimal answer.
d. Now get the high price for this year from Section 3 and multiply the high price by this decimal value.
e. Finally, subtract this number from this year's high price to get the potential low price for the year.
For example, the average five year high price is not given
on the back of the SSG in Section 3, line 7, column A. You need to add the
figures together in Section 3, column A, lines 1, 2,
3, 4, and 5. Then divide the sum of these lines by five to get the average five
year high price. The five year average low price is found in Section 3, line 7,
column B. Assume the five year average high price is $50.00 and the five year
average low price is $35.00. The high for the current year is $60.00. To
$50.00 - $35.00 = $15.00
$15.00 divided by $50.00 = 0.30 or 30%.
Thus, over the last 5 years the low price has been 30% below the high price. The current price is $60.00 and 30% of it is $18.00. Thus, the expected low price from this method is $60.00 - $18.00 or $42.00.
5. Another method which has been used is "any stock can drop by 20% at any time". To determine this value, simply multiply the current price by 0.8 to get this estimated low price.
Section 4C: Zoning
The high and low forecast prices are used in a formula to create buy-hold-sell zones. The price ranges are divided into thirds (33%-33%-33%) called the "Buy," "Hold or Maybe," and "Sell." Toolkit permits you to change the ranges to 25%-50%-25%. This is a more conservative approach and is recommended. This can be done by clicking on Preferences at the top of Toolkit, then select Stock Study, scroll down to Zoning Default and click on 25-50-25.
Rule of Thumb: Consider buying the stock only if the price is in the lowest 1/4th of the range between the low and high price. This will mean the stock is in the "Buy" range. It is important how you interpret this information. When the price is in the buy zone, it doesn't mean you should buy the stock. Instead it means the price is in the buy range. Investors should consider all sections of the SSG, as well as other outside research, before purchasing stock in a company.
Julie Werner, BetterInvesting Instructor, states: "Perhaps the zones should be reworded: BUY, MAYBE, DON'T BUY (instead of SELL). If the price is not in the BUY zone, then do not buy; wait until the stock does come into the buy zone. One of the reasons people fail in the stock market is that they pay too much."
Section 4D: Up-side Down-side Ratio (Potential Gain vs. Risk of Loss)
The upside-downside formula determines the risk involved in buying the stock at the current price. The ratio shows the amount of potential price appreciation (upside) compared to the possible amount the stock price could reasonably fall (downside) over the next five years.
Section 4E: Price Target:
This shows the potential market price appreciation over the next five years in simple interest terms. An appreciation of 100% (a doubling in price) is desired if no dividend is paid. If the price appreciation is less than 100%, a dividend yield could help make up the difference.
Relative Value is the Current P/E divided by the historical P/E (or five-year average of the high and low P/Es) or if you have eliminated some of the values in Section 3 D and E, it will be the Current P/E divided by the signature or P/E. Relative Value is the relationship between the Current P/E and the Average P/E and is expressed as a percentage. The Relative Value shown on the SSG uses earnings figures for the "past" 12 months.
Since P/E's can be bloated at certain times, Relative Value can be misleading. Thus it is important to eliminate any outliers which make the P/E's higher than normal.
Rule of Thumb: You want to purchase stocks with a relative value between 80-110%. This means the current P/E is very close to the historical or average P/E and thus a good buy. It is often referred to as being a value stock according to its current P/E.
If the relative value is below 80%, it means the stock is undervalued. It might be a great bargain or there might be something going on in the company that will adversely affect earnings. You need to find out. Usually the price is severely depressed for some good reason. If the Relative Value is above 110%, the stock is overvalued.
Projected Relative Value:
Projected Relative Value is calculated using the estimated earnings for the "future" twelve months. The projected relative value is always a lower number than relative value since the estimated earnings figure will be higher but the price figure stays the same. This serves as a conservative check on relative value, or this is a more conservative approach to evaluating relative value.
"Understanding the SSG…Or You Will buy Turkeys When It's Not Thanksgiving," A Learn and Darn Feature by Ed Chiampi, Better Investing, April, 1998. Also available at http://old.better-investing.org/bi/le/le-apr98-7.htm
"Stock Selection Guide Seminar, Saturday, May 16, 1998. Online at ftp://better-investing.org/pub/i-club-list-files/ssg-seminar.txt
"Advanced SSG Topics," Bob Adams,
"Critiquing and Adding Judgment to
SSG," Gary Ball, NAIC Congress,
"Interpretation of the
Stock Selection Guide, Julie Werner, handout at the NAIC Congress,
The SSG - Beyond the Mechanics, Gary Simms and Candis Kink, July 1998. Online at http://old.better-investing.org/ftp/misc/beyond-mechanics.tx