Stock Research

Fundamental Stock Research

Fundamental stock analysis is a very business like and logical approach to investing. It is finding companies to invest in that are very likely to return to you value in the form of profits. The challenge is figuring out what you want to own and the price you're willing to pay. But just how does that work?

The best way to explain this concept is with an example. Let's say you're paying a visit to your local Home Depot. You walk in the store and they've got ten brand new snow blowers lined up and they are on sale for only $100. That is a fantastic price, but the problem is that you live in Florida. So you see how this is an important point? You need to balance both - what stocks you want to own and the price you are willing to pay.

Excellent Stocks

To us the most logical approach to researching stocks is to first figure out what kinds of stock you are interested in buying. When we think of the kinds of stocks we would want to own, there are two elements to this decision.

The first is individual because you should own stocks of companies that are in a business that you understand. If gene splicing is a foreign subject to you, then stay away from those companies. The second element of this question is philosophical. Our suggestion is to follow the advice of Warren Buffet and invest in excellent businesses that have expanding value.

Let's explain why we need to look for an "excellent" business and what that means. When we're conducting stock research there are tens of thousands of companies to screen out and choose from. In that universe of stocks there are excellent companies - Coca Cola, General Electric, and Walt Disney to name just a few. But there are also many "commodity type" businesses that should be avoided.

Commodity Businesses

A commodity is generally described as a product that is essentially the same from manufacturer to manufacturer and the primary purchase motivation is price. Oil, rice, steel, lumber, paper, all these products are commodity items. These "second-rate" or commodity type businesses have certain traits that will allow you to quickly identify them:

1. Absence of brand loyalty - that's because brand loyalty usually commands a premium price
2. Multiple producers - many companies making the same thing means a lot of price competition
3. Excess production capacity throughout in the industry

These three traits translate into low profit margins and low returns on equity - something that investors like to avoid.

Please understand that just because a company sells a "commodity-like" item, does not mean that it is a commodity business. It must exhibit all three of the traits above to be a commodity business.

For example, let's say that in your stock research, you come across the company Starbucks. Well, they sell coffee and coffee beans are traded on the commodity exchange. But Starbucks also has a lot of brand loyalty - so it would not be considered a commodity business.

Prices Paid for Excellent Companies

Now we should understand that it makes sense for us to invest in excellent businesses and how to identify one. We will now begin to explain how to figure out the price we might be willing to pay for one of these excellent companies.

Stock Price Research and Intrinsic Value

We will now begin to talk about how to calculate the price we might be willing to pay for a share of stock in an excellent company. The first step is to examine the stock against a standard or benchmark. In this example, we're going to use the one year Treasury Bill rate. At the time of this article the rate is around 2.2%.

Calculating Intrinsic Value

We'll examine the stock against this particular government bond because as an investor, you have options available to you. You have the opportunity to invest at a risk free rate of 2.2% or place your money on a considerably riskier investment and hopefully realize higher returns. The value of a stock relative to government bonds is termed intrinsic value. Let's look at an example of how intrinsic value is calculated.

Example Calculation - Intrinsic Value

The 3M Company is a component of the Dow Jones Industrials. It is currently trading around $70 / share with 2006 earnings estimate of $4.48. Again using the benchmark of the government bond at 2.2%, we can estimate the intrinsic value of 3M Company as $4.48 / 0.022 = $203 / share. This calculated intrinsic value is far in excess of the $70 range in which 3M is currently trading.

Remember that the point of calculating intrinsic value is to compare this value for 3M to that of a government bond. With projected earnings of $4.48 and a share price of $70, 3M's return on investment (based on earnings) would be $4.48 / $70 or 6.4%, nearly three times the current return you'd realize by holding a government bond.

Therefore, the intrinsic value of 3M would be nearly triple the current market price of its stock at $70, which compares favorably to our calculated value of $203 / share - it all makes sense. We now know how to calculate a stock's intrinsic value.

Calculating Return on Equity

The next calculation we'll take a look at is the return on equity. The return on equity is calculated by taking net income and dividing it by stockholders equity. This value is important to understand when conducting stock research because net income is the money that is left over after paying for all the expenses needed to run a company. Those expenses including cost of goods sold, selling general and administrative expenses, depreciation, interest expenses and income taxes.

When all these expenses are subtracted from the revenues of the company we have net income. 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 = 31.7%.

Researching Earnings per Share

The reason earnings per share is so important to understand is because it is possible to estimate a company's future stock price by using the company's earnings per share annual growth rate. That is to say, if we understand the growth rate of earnings, it is then possible to develop an estimated future stock price. In turn, if we understand how many years it will take for a stock to reach a projected value, then we can calculate an annual rate of return the stock will give back to us.

Earnings per Share Example

To see how this works, we are going to use another example. For the past 5 years, 3M's net income has grown at an annual rate of about 7.6 percent. We can use this growth rate along with net income to project 3M's earnings forward for 5 years. In this example, the 3M 2006 earnings per share value of $4.48 and use a compound annual growth rate of 7.6% (4.48 x (1.076)^5 = $6.46. So using this example, we project 3M's earnings per share value to be $6.46 in 2011.

Calculating Price Per Share

The next step is to look at the historical Price to Earnings (P/E) ratio for 3M. Over the last 5 years, the P/E ratio for 3M has ranged from a low of 15.8 to a high of 34.4. If we take a conservative approach and use the lower value of 15.8, we can then multiply this value times our projected earnings per share value to develop an estimated stock price for 3M in 2011. Continuing with the example, $6.46 x 15.8 = $102.07. So our expected market price for 3M in 2011 is $110.56.

Projecting Growth Rates

The next step on our research is to project the annual rate of return if we were to invest in 3M today. Right now, 3M is selling for around $70 per share. To solve this problem, you need to solve an equation, using Excel or a financial calculator - sorry. The formula you want to solve is this $70 x (1+X) ^5 = $102.07, determining the value of X. I've already done this for you and the answer is 7.8%. This means that if we purchase stock in 3M today, we are projecting an annual rate of return on that investment (based on stock price growth) of 7.8%.

In order to determining where we might want to invest our money we would repeat this exercise for all of the excellent businesses. We would also want to take a look at earnings stability. For example, as part of our research on a company, we would want to know what is causing an increase in earnings per share. Is it the economy and good business practices? Or are earnings on the rise because of fancy financial maneuvering?

Using Net Earnings to Gauge Stability

One way to cut through to the stability of earnings question is to look at the net earnings of the company and the annual compounding rate for that value. Growth in net earnings helps you understand if the company has been repurchasing stock to boost earnings per share growth.

Since earnings per share is determined by dividing net earnings by the number of outstanding shares of stock, a decrease in the denominator (shares of stock outstanding) will result in a higher earnings per share value. If we examine the net earnings values over a number of years and calculate the compound annual growth in earnings, we can get a better feel for earnings stability and future growth.

Stock Research Example

Over the remainder of this article we will put together an example that pulls together all that we've learned so far. By using the information in all four of these articles on stock research, you should have a pretty good process for evaluating stocks. That being said, let's look at an example.

Finding Excellent Stocks with Expanding Value

We've used 3M in the past, so we'll stick with that company as we do our research. The first set of questions to ask is:

* Do they do they sell commodity-type products?
* Is there a lot of competition?
* Do they have brand loyalty?

Well, 3M is a pretty big company, so let's simplify this example by focusing on their Consumer and Office Products line. Certainly a lot of people have heard of Scotch(r) Tape, Post-it(r) Notes, and Scotchguard(tm). So it seems they have some brand loyalty. While we know there are companies that make competing products, we would think that competition is pretty low.

The other thing this product line has going for it is that they are selling consumables. This means that people use the product and then have to go buy more at the store. Selling consumables with brand loyalty is a very good thing. It's reasonable to conclude that 3M passes the test and would be considered an excellent business.

Calculating Intrinsic Value

The next exercise is to calculate the intrinsic value of 3M. We've done this already, but let's review those calculations again. The company was trading around $70 / share with 2006 earnings estimate of $4.48. We need to use a benchmark of the government bond - 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 / 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 we'll take a look at is the 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 = 31.7%. You can compare this value to other companies to figure out how the 31.7% compares to other stocks you're analyzing. Our guess is that 3M will stack up pretty well in this department.

Examining Financial Statements

We should also take a look at the financing of the company - just one of the many financial ratios at our disposal. The debt to equity ratio of 3M is only 0.24 compared to the industry average of 2.12. This means that 3M has very little debt compared to stockholder's equity. This puts 3M in a very good light because 3M should have no problem making any of its debt payments.

Stability of Earnings

As a final step we would want to look at the stability of earnings per share growth to make sure current earnings is not due to unusual circumstances. For the past five years, 3M's net income has grown at an annual rate of around 7.6 percent. We can use net income to project 3M's earnings forward for five years by taking 2005 earnings per share value of $3.02 and applying a compound growth rate of 7.6% (4.48 x (1.076)^5 = $6.46. In this example, 3M's earnings per share value to be $6.46 in 2011.

Using P/E to Project Future Stock Prices

Now we want to look at the Price to Earnings or P/E ratio for 3M. The P/E ratio for 3M has ranged from a low of 15.8 to a high of 34.4. If we use the lower value of 15.8, we can then multiply this time the projected earnings per share of $6.91 value to develop a projected stock price for 3M in 2009. Doing the math - $6.46 x 15.8 = $102.07. Meaning our expected stock price in 2011 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. The formula you need to solve is:

$70 x (1+X) ^5 = $102.07, determining the value of X

This works out to be around 7.8%. So if we were to purchase stock in 3M today, we are projecting an annual rate of return on that investment of 7.8% over the next five years.

We're done, we're finished! But this is just one stock. To really do a thorough job of researching stocks, you need to go through this same exercise many times in order to develop a list of the most desirable companies.

Nobody said stock research would be easy, and certainly personal computers will help. On the other hand, doing your own research should give you a sense of personal satisfaction and hopefully many monetary rewards too.

Source : www.money-zine.com