CRMIC - Stock Selection Guide

Stock Selection Guide

CAPITALIZATION: FRONT SIDE OF SSG (Upper right hand corner)

Company:	Paychex, Inc.3	Date:	08/19/02
Prepared By:		Data taken from:	Value Line
Where traded:	Nazdaq	Major product/service:	Computer So
CAPITALIZATION:	Outstanding Amounts	Reference:	Issue 13

Chart

Information for Preferred Stocks Outstanding ($M - given in terms of dollars not number of shares), the number of Common Shares Outstanding ($M - cite numbers in millions, e.g., 74.5 rather than 74,478,061), and Total Debt ($M - cite numbers in millions) is taken from the Capital Structure Section of Value Line.

% Insiders: The % of common shares owned by Insiders, which is defined as directors and officers, is found in Value Line under the Business Section, located in the middle of the page. Benchmark: Insider ownership is good since it indicates that those making decisions in the company are making them in their own interests as well as the investors’. In Small Capitalization companies it is desirable to have 25-30% of the company owned by the insiders. In Large Capitalization companies it is desirable to have 1% of the company owned by the insiders. See Advanced Information for Insider and Institutional Holdings.

% Institution: This % is not found in Value Line. It is computed by dividing the total number of common shares owned by institutions by the total number of common shares outstanding. The number of Institutional Holdings is found in the Institutional Decisions Section of Value Line, and the common shares outstanding is found in the Capital Structure Section of Value Line. Benchmark: As investors, we like to see no more than 40-50% of the common shares owned by institutions. If institutions hold more than this, find out how many institutions own shares. This information can be found online at sites such as Quicken.com. As small investors, we do not want a few companies owning a large piece of the company because institutions buy and sell frequently. If they sell at the same time, our stock will quickly lose its valuation. This often happens when small investors least expect it to happen. Remember: institutional investors are short term holders. See Advanced Information for Insider and Institutional Holdings.

Company's Size according to Capitalization OR according to Revenues: There are two ways to look at the size of a company. One is by the size of the company’s capitalization and the other way is based on the amount of the company revenues (or sales).

Company's Size According to Capitalization: A calculation is involved to determine whether a company is a large-cap, mid-cap, or small-cap company. To calculate capitalization multiply the current number of common shares outstanding by the current share price. Capitalization changes every time the share price changes, and share price can be significantly affected by investor sentiment. Keep in mind that the following dollar amounts are arbitrary. As stock prices increase over time, investment market analysts have moved up their cutoffs. A standard used to determine a company’s capitalization size is as follows:

Company Size according to Capitalization	Value of Capitalization* (This varies according to source used)
Small-Cap Company	Value less than $2 billion/year
Mid-Cap Company	Value between $2 billion and $10 billion/year
Large-Cap Company	Value greater than $10 billion/year

Company’s Size According to its Revenues: Many investors prefer determining a company’s size using the amount of the company’s sales or revenues as opposed to measuring a company’s size according to market capitalization. Defining a company’s size by its revenues is an alternative method that puts a company on equal footing with other companies. Keep in mind, that if a company is not generating sales, the company will not be able to operate for an extended period of time. Without sales a company is doomed to failure.

CRMIC uses the standard of sizing a company according to its revenues. The standard that is used is as follows:

Company Size	Revenues**
Small-Sized Revenue Company	Revenues less than $500 million/year
Medium-Sized Revenue Company	Revenues between $500 million and $5 billion/year
Large-Sized Revenue Company	Revenues greater than $5 billion/year

Expected Growth in a Company:

It is also important to understand that as a company gets larger, it is more difficult for it to continue growing as fast as it did. It is more difficult for a company generating $1,000,000,000.00 in sales to double its sales to $2,000,000,000.00 in the following year than it is for a company generating $1,000.00 in sales to double its sales to $2,000.00 in the following year.

The following chart displays the expected growth for companies according to their size based on revenues:

Size of Company	Annual Sales	Expected Growth
Small-Sized Revenue Company	$50 million to $500 million	15+%
Medium-Sized Revenue Company	$500 million to $5 billion	10-15%
Large-Sized Revenue Company	Over $5 billion	7-10%

Most investors like to see annual earnings growth of 15% on average when investing in growth companies. This does not mean that every company in a portfolio must have 15% growth. The 15% rate is an average of the growth of all the companies in a portfolio. For example, you can accept lower growth in larger, established companies because of the stability they provide. By the same token, you need stronger growth in smaller companies to make up for their riskiness and lack of stability. Medium-sized companies are a compromise in that they can grow faster than large companies. However, they are not as risky as small companies.

% of Debt to Total Capitalization: If using the Toolkit software, this percentage is calculated by the computer and is based on total debt. The percentage is found in Value Line under the Capital Structure Section, which is in the left hand column. The percentage found in Value Line refers to Long Term Debt. Benchmark: An investor wants the Total Debt of a company to be less than 33% of the Total Capitalization. If looking at Long Term Debt instead of Total Debt, less than 25% is desirable in most cases. The company has to pay interest and regular payments of principal on borrowed money from institutions (debt), but it pays no interest nor payments of principal on money from its investors who own common shares of the company. This is important during bad times when creditors' demands upon the company's cash can impair its ability to survive. Note: The significance of the debt-to-capital ratio will vary with the type of company. Companies that trade on debt are in a different set of circumstances. Financial institutions, insurance companies, and utilities are not subject to the same rules governing typical manufacturers, retailers, or service providers.

% of Potential Dilution: Dilution is debt that can be converted to common shares. (None is desirable.)
Dilution occurs in three ways:
1. Issuing additional shares of common stocks.
2. Issuing convertible debentures. These are purchased as bonds (money lent to a company) but may be turned in for common stock at a later date and at the discretion of the holder.
3. Issuing stock options as compensation to employees. This allows the employee to cash in at a later date on the company's growth.
Use the following formula to calculate the percent of potential dilution:
Dilution % = Basic EPS divided by Diluted EPS times 100 minus 100

ADVANCED INFORMATION FOR INSIDER AND INSTITUTIONAL HOLDINGS

The Motley Fool
From The Fool School: Insider and Institutional Holdings

When investigating small companies as possible investments, it is good to learn who else owns a share.

For example: Insider holdings are generally a good thing. Executives who own 30% of a company are motivated to make it succeed. Insiders buying shares is also usually good, as it means they expect the shares to rise. Do not be alarmed by insider sales, though. Company stock is a major component of many executives’ compensation. It is natural for them to occasionally sell some shares to send a child to college or pay for skydiving lessons. Lots of executives selling might be a red flag, though.

With small companies, we like to see insiders owning 15% or more, and little institutional ownership.

Institutions, like mutual funds and pension funds, are the major players. They buy or sell in enormous chunks, and whether a stock is in or out of their favor can have a big effect on its price.

When small companies have little or no institutional ownership, it is often because the big players are sidelined. Small firms usually have relatively few shares outstanding, and their total worth is modest. An example: Scruffy’s Chicken Shack (ticker, BUKBUK, slogan “Tastes Like Chicken”). It has 20 million shares outstanding, valued at $5.00 each. Total market value: $100 million.

Institutions that might typically buy $10 million worth of shares cannot do so with BUKBUK without buying fully 10% of the entire company, something they’re often prohibited from doing.

Here is where opportunity creeps in for investors like you who discover Scruffy’s and snap up shares. In time, Scruffy grows and Wall Street takes notice. Institutions begin buying shares, in their usual big way. All that demand pushes up the price of the stock – and you clap your hands in glee. In other words, you bought into the company before institutions took notice and ran up the price.

Discovering a small but growing company with significant insider ownership and low institutional ownership is a promising prelude to finding a rewarding investment – provided all the financial measures are sound. You can call any public company and ask its investor relations department about insider and institutional ownership. Just remember that small companies are best suited to investors with a few years of experience.