Here's a piece from the author of Portfolio Planning for Individual Investors on his recommended method for selecting stocks:
Most individuals desire to invest well, but somehow with the information overload we are all subjected to on a daily basis, many become hopelessly lost in the stock selection process. These individuals eventually either turn over their investment decisions to investment professionals, or just settle for mediocre results. It is important to remember that no outsider is more interested in your wealth maximization than you are; therefore, it is essential that individual investors have the tools necessary for common stock selection.
The six-step stock selection process explained below provides the investor with a time-tested method for successful stock selection. The steps in this method are screening tools used to reduce the number of stocks under consideration from over 5,000 to a workable number, less than 100. Many individuals fall in love with various stocks and tend to select those stocks even though they fail one or more of the six steps. It is imperative that stocks that fail any of the six steps are discarded!
The first step requires that each stock has continuous earnings per share (EPS) growth for the most current three periods. The last four years contain three periods (2003-2004, 2004-2005, 2005-2006). The six-step method is based on the concept of value investing, where value is a function of EPS. When one considers that stock price is equal to price/earnings multiple (P/E) multiplied by EPS, it is easy to see that if P/E is held constant and EPS is increased, stock price will increase. Numerous studies have found that a company’s EPS has a sense of inertia, that is, a body in motion tends to remain in motion. Therefore, a company with a history of continuous earnings growth has a much better chance of maintaining that growth than a company with a poor earnings growth record. This first step will eliminate the number of stocks under consideration by about 90%. A second part of this step is to calculate the EPS growth rate of all stocks with continuous EPS growth for three periods, using a financial calculator.
The second step requires that each stock’s EPS growth rate exceeds its required rate of return. The required rate of return is calculated using the Capital Asset Pricing Model (CAPM) as follows: Required ret. = Risk-free ret. + Beta(Market ret. – Risk-free ret.). The risk-free return is the 20-year average return for T-Bills (4.6%), the market return is the 20-year average return for the S&P 500 Stock Index (13.2%), and the beta for each stock is found in The Value Line Investment Survey.
The third step requires that each stock must pay a dividend. During the market boom years of the 90’s, most investors paid little attention to dividends. However, since the 2000 – 2002 bear market, investor sentiment concerning dividends has changed for two primary reasons. First, in 2003 the maximum tax paid on qualified dividends was reduced from 38.6% to 15%. Second, for the past 20 years dividend paying stocks have out-performed non-dividend paying stocks by approximately 3% per year. In addition, since there are only two possible cash flows associated with common stock investing, dividends and the final sale of the stock, why would a prudent investor choose non-dividend paying stocks?
The fourth step requires that each stock have good ratings from Standard and Poor’s and The Value Line Investment Survey. To pass the fourth screening stocks should have a Standard and Poor’s rating of at least “B” and Value Line ratings of at least 4 for timeliness, 3 for safety, and “B” for financial strength.
The fifth step requires that a stock only be considered for purchase if its intrinsic value is greater than its present market price. The stock’s intrinsic value is calculated by discounting its estimated dividends and selling price over the forthcoming three years as follows:
V = D(1 + g) /(1 + R ) + D(1 + g)2/(1 + R)2 + D(1 + g)3/ (1 + R)3 + (P)(E)(1 + g)3/(1 +R)3
While this calculation appears difficult, it is actually very simple. The notation is as follows: D = current dividend, g = growth rate in EPS, R = required rate of return, t = time in years, P = price/earnings multiple, and E = current EPS. The first term is the discounted value of the estimated dividend in year 1, the second term is the discounted value of the estimated dividend in year 2, the third term is the discounted value of the estimated dividend in year 3, and the fourth term is the discounted value of the stock’s estimated price at the end of year 3.The sixth step requires that each stock pass a financial statement analysis (FSA), either a full blown FSA, or an abbreviated FSA. A full blown FSA consists of a trend analysis (trend of financial ratios for past three years), a comparative analysis (comparison of company’s financial ratios to its industry averages), a common-size income statement analysis (a percentage analysis of the income statement), and a bankruptcy prediction, if deemed necessary. Although a full blown FSA is more accurate, most investors settle for an abbreviated analysis which typically includes one financial ratio from the areas of liquidity, debt management, efficiency, and profitability as follows:
Current ratio (liquidity) = Current assets/Current liabilities – this ratio should be above 1.8 for firms with inventory and accounts receivable, and 1.0 or above for all others.
Debt/Equity ratio (debt mgmt.) = Long-term debt/Stockholders’ equity – this ratio should be less than 100%.
Average collection period (efficiency) = Accounts receivable/Average sales per day – use
the company’s industry average from Risk Management Association Annual Statement Studies for the acceptable average collection period.Return on equity (profitability) = Net income/Stockholders’ equity – The return on equity should be greater than 10%.
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