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This is the final article in our series on stock research. In this publication, we will pull together an example that reviews everything we've learned up to this point. That takes us back three articles, so let's summarize everything one last time.
Stock Research Lessons
Outlined below is what we've learned so far in this series on stock research. The information found in these articles will be pulled together into one final example.
Stock Research Example
Over the remainder of this article, we are going to review an example that summarizes the techniques covered in this series. By using the information in all four of these articles on stock research, you should have a good process for evaluating stocks.
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 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. Certainly a lot of people have heard of Scotch® Tape, Post-it® Notes, and Scotchguard™. So it's safe to assume they have some brand loyalty. We know there are companies that make competing products, but think that competition is pretty low.
The other factor 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, along with brand loyalty, is a very good position to be in for any business. 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 per share, with a 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 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 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% measures up to the 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 stockholders' 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 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 around 7.6%. 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, we project 3M's earnings per share value to be $6.46 in five years.
Using P/E to Project Future Stock Prices
Next, 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 value times the projected earnings per share of $6.46 to develop a projected stock price for 3M in five years. Doing the math: $6.46 x 15.8 = $102.07. This means our 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. The formula you need to solve is:
$70 x (1+X) ^5 = $102.07, determining the value of X
This equation 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 with 3M! But this is just one stock. To 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.
No one said stock research would be easy, and certainly a personal computer will help with the necessary calculations. Doing your own research should give you a sense of personal satisfaction, and hopefully monetary rewards too.
About the Author - Stock Research Part IV
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