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Stock Selection Guide
OVERVIEW OF THE
STOCK SELECTION GUIDE
PURPOSE: The Stock Selection Guide (SSG) has two purposes.
- The first is to determine the
quality of the company. If the company under consideration is strong and
healthy, then it warrants further study.
- The second is to determine if
the stock is selling at a price that would make it an attractive
investment. No matter how good the company appears, it is not a good
investment if the stock is over-priced. The goal is to double the invested
money in five years.
OVERVIEW: The SSG is divided into five sections: the first two deal
with the quality of the company being studied and the last three deal with
value. The investor needs to determine if the current price is positioned to
double its value in five years.
QUALITY OF THE COMPANY: Sections 1 and 2 of the SSG allow you to
judge the quality of a company.
- Basic Data and Capitalization: The
box in the upper right-hand corner of the SSG identifies the company and
information about how the company is financed.
- Recent Quarterly Figures: The
quarterly figures data in the left-hand box reports the company’s recent sales and
earnings performance and is an indicator of the recent success
or failure of the company.
- Visual Analysis: This
section deals with the historical growth of sales, earnings, pre-tax
profit, and stock prices over a 10-year period. When these criteria
are plotted on a semi-log graph, you can see if the growth has been stable
and strong enough to deserve your interest. The historical data serves as
a guide to estimate sales and earnings per share for the next five years.
Section 2: Evaluating Management. Assuming that the
growth is satisfactory, the second item is determining if management has the
capability to sustain growth.
- Section 2A on the SSG
displays the Pre-tax Profit (PTP) margins in relation to the company's sales and allows you to see if the profit margin
is stable, increasing, or decreasing. Note whether the PTP is trending up, down, or is stable.
- Section 2B displays Return on
Equity (ROE), which tells you whether management is able to earn a steady
and substantial return on investors’ money. Note whether ROE
is trending up, down, or stable.
VALUE OF THE COMPANY: If – and only if – you determine from the above
that the company is a good quality company, then the next issue is the price of
its stock. In the next three sections of the SSG, the objective is to determine
if the value of your investment has the potential to double in five years.
Section 3: Price-Earnings History. This section deals with the
historical relationship between earnings and the price of the stock. It
calculates historical averages that are used to develop estimates of future
price ranges. It also deals with the company’s performance in paying dividends.
Section 4: Evaluating Risk and Reward. In Section 3 you determined
what you believe to be the highest P/E and the lowest P/E that investors would
be willing to pay for this company’s stock. You made a conservative forecast of
the highest and lowest earnings per share that this company might make,
assuming the company operates normally. These numbers are used in Section 4 to
calculate the potential for risk and reward.
- Section 4A: This section
determines the high price for the next five years. This is done by
multiplying the highest P/E multiple by the highest forecast earnings.
- Section 4B: This section
determines the low price for the next five years. This is done by
multiplying the lowest P/E multiple by the lowest forecast earnings.
- Section 4C: Once the price
range (from the highest to the lowest) is determined, then you determine
how the current price compares with that range. This is known as zoning.
- Section 4D: This section
shows how the risk you would take compares with the potential reward. This
is known as the Up-side Down-side Ratio.
- Section 4E: This section
shows how the current market price should appreciate over the next five
years in simple interest terms. This is known as the price target. This
sections also deals with how the current P/E multiple compares with the
average 5-year P/E multiple. This is known as relative value.
Section 5: Five-Year Potential. This section looks at
the dividend income. Then it calculates the possible total return you might
expect to receive on your investment when a company pays a dividend. The total return
is based on the current market price.