This is the last in a four part series aimed at explaining a fundamental approach to selecting stocks. In this article, we'll summarize what was learned; then use an example to review the information appearing in each of the earlier articles in this series.
Stock Research Lessons
Outlined below is what we've reviewed so far in this series. The information found in these articles will be pulled together into one final example.
Additional Resources
Stock Research Part I Stock Research Part II Stock Research Part III Calculating Stock Prices Capital Asset Pricing Model Arbitrage Pricing Theory Stock Beta and Volatility In Stock Research Part I, we learned how to identify excellent companies that had expanding value.
In Stock Research Part II, the focus was on calculating the intrinsic value of a stock.
Finally, in Stock Research Part III, we learned how to calculate growth in earnings per share, make projections of a stock's future price, and calculate an annual rate of return on the investment.
Stock Research Example
Over the remainder of this article, we're going to review an example that summarizes the techniques covered in this series. By using the information in all four of these articles, it's possible to understand, and develop, a sound process for evaluating and selecting stocks.
Finding Excellent Stocks with Expanding Value
We'll continue this example using the 3M Company. The first set of questions to ask is:
Do they sell commodity-type products?
Is there a lot of competition?
Do they have brand loyalty?
We know that 3M is a very big company that offers many products. Let's simplify this example by focusing on their Consumer and Office Products line. Most consumers will be familiar with product names like Scotch® Tape, Post-it® Notes, and Scotchguard™. So it's safe to assume 3M enjoys some brand loyalty. We know there are companies that make competing products, but believe competition is fairly low and those products are typically inferior in quality.
The other factor this particular product line has going for it is that they are selling consumables. This means that people use the product, then have to buy more after a short time. Selling consumables, along with brand loyalty, is a very good position to be in for any business. It's reasonable to conclude that 3M passes this first test, and would be considered an excellent business.
Calculating Intrinsic Value
The next exercise is to calculate the intrinsic value of 3M's stock. This was done in an earlier article, but we're going to review those calculations again. The company was trading around $70 per share, with a 2006 earnings estimate of $4.48. We need to use a risk-free investment benchmark, which is the 1-year T-Bill rate of 2.2%, to calculate intrinsic value:
Estimated Earnings per Share / Benchmark = Intrinsic Value, or
$4.48 / 0.022 = $203 per share
The intrinsic value is far in excess of the $70 range in which 3M is currently trading; so 3M easily passes the intrinsic value test.
Calculating Return on Equity
The next calculation to perform is the company's return on equity. The return on equity is calculated by taking net income and dividing it by stockholders' equity. Net income is the money available to the shareholders of the company.
In 2005, the 3M Company had net income of $3.2 billion. According to the company's 10-K filing, stockholder's equity was around $10.1 billion. Therefore, for 2005, the return on equity is calculated as $3.2 billion / $10.1 billion, or 31.7%. This value should be compared to other companies in the same industry to figure out how the 31.7% measures up; analyzing the value in both absolute (standalone) and relative (industry) terms.
Examining Financial Statements
It's also important to examine the leverage of the company, which is just one of the many financial ratios to consider. The debt to equity ratio of 3M is only 0.24 compared to the industry average of 2.12. This means 3M Company has issued very little debt relative to stockholders' equity.
Stability of Earnings
The final step in this process involves looking at the stability of earnings per share growth to make certain that current earnings are not due to unusual circumstances. For the past five years, 3M's net income has grown at an annual rate of 7.6%. We can use net income to project 3M's earnings five years in advance by taking the 2005 earnings per share value of $3.02 and applying a compound growth rate of 7.6%. Following the equation outlined earlier, we'd have:
= $4.48 x (1.076)5, or $6.46
In this example, we project 3M's earnings per share value to be $6.46 in five years.
Using P/E to Project Future Stock Prices
Now it's time to examine the Price to Earnings or P/E ratio for 3M. This ratio has ranged from a low of 15.8 to a high of 34.4. Using the lower value of 15.8, we multiply times the projected earnings per share of $6.46 to develop a future price.
$6.46 x 15.8 = $102.07
This means 3M's expected stock price in five years is $102.07.
Projecting Annual Rates of Return
Finally, we're going to finish up our stock research by projecting the annual rate of return if we were to invest in 3M today. Again, 3M is selling for around $70 per share, and the formula to solve is:
Growth Rate = ((Projected Market Price / Current Market Price)(1/Number of Periods)) - 1
As demonstrated earlier, this example works out to be a growth rate of around 7.8%. Meaning an investor purchasing stock in 3M should expect an annual rate of return on that investment of 7.8% over the next five years.
That completes the analysis of 3M; but this is just one stock. To do a thorough job, this same exercise must be repeated many times to develop a list of the most desirable companies to own. As the above example demonstrates, selecting stocks is not a trivial task. Fortunately, computers make this exercise much easier. The mere act of conducting this research allows investors to understand the financial health of the companies they own.
About the Author - Stock Research Part IV
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