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 Here is the final installment on stock research; this is it - at least for now. We've finally come to the end of this series and we will put together an example that reviews all we've learned about stock research. And that takes us back three articles, so let's summarize everything one last time.
Stock Research Lessons
Summarized below is what we've learned so far in this series on stock research. The information found in those articles will be pulled together into one final example.
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 along with brand loyalty is a very good position to be in for any company. 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 20011. 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.
About the Author - Stock Research Part IV
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