Douglas Gerlach: SSG Tutorial

Stock Selection Guide Tutorial

Visual Analysis of Sales, Earnings & Price

Estimating Historical Growth

While this is one of the most crucial areas of the Stock Selection Guide, the techniques for estimating historical growth are not that difficult. The key is to identify consistent trends in the company's growth over the past ten years.

Before putting pencil to paper, however, you should look carefully at the graphed data to see if there are any years which appear to be abnormal. Perhaps EPS dropped off significantly in one year, only to rebound the next. In that case, you might consider that year to be an "outlier", an unusual, one-time occurence, and simply not consider it in your calculations. Circle the point in question to mark it as an outlier, and continue with your analysis. Of course, any inconsistency may be a cause for further research to determine if there is a significant change in the company's operations.

To identify the past trends, use a ruler to draw a trend line to approximate the average annual growth for both EPS and Revenues, a single straight line that best "matches" the points you have already graphed. In this company's case, you will draw your trend lines all the way from the farmost left vertical line, the 1986 year, all the way to the furthest right year, 1999. There are four basic methods of drawing trend lines:

The Inspection or Best Judgement Method

By far the most common method of drawing a trend line, the "Best Judgement" method simply means that you examine the yearly results and draw a line that best represents the overall picture of those years. The following is an example of a trend line for Earnings Per Share drawn using the Best Judgement method.

In this case, EPS have been very consistent, so it is relatively easy to determine the trend.

The Peak Period Method

This procedure is often used for more cyclical companies, those whose earnings or revenues increase to a "peak" and then recede. Find the two most recent of these peaks and draw a line that connects them.

The Mid Point Method

This method produces a mathematical result that will be exactly the same for all who use it. It requires that you find the average of the first five data points, plot that point on the graph, find the average of the last five data points, then plot that point on the graph, and draw a straight line that connects those two points.

The Area Method

To use this method, place your trend line so that the area between your trend line and the drawn lines connecting the data points is equal both above and below the trend line.

Having drawn a trend line, you can now measure the growth rate by comparing this trend with the graph's pre-drawn percentage growth lines (marked 5%, 10%, 15% and so on). An easy way to do this is to measure the distance between the intersection of your trend line on the far left vertical line (the first year of data) and the horizontal base line (marked 1). Then go to the intersection of the trend line and the most recent year (the bold vertical line). Measure down the same distance as the first year and mark this point. Now, visually estimate where this point falls between the pre-drawn percentage growth lines (for instance, halfway between 15% and 20% would be 17.5%). This is the average rate of historical growth. Repeat for both EPS and Revenues, and mark the growth rates you have determined at the bottom of the Visual Analysis.

Projecting Future Results

Once you have estimated the historical growth of the stock you are studying, you need to make a decision about the company's future prospects. Is growth likely to continue at the same rate in the future? Will the company's growth slow, or even increase from its historical pattern? Common sense tells us that good growth stocks are able to continue their growth, but they may not be able to grow as quickly as they have in the past. It may be prudent to allow for a slowing of growth in the future, especially with high-flying companies that may find it hard to sustain their rapid growth.

Now, extend the historical trend lines, or draw new trend lines to reflect your expectation of the company's future growth. Draw your new line all the way from the far left to the far right margins, and, as before, measure the distance to calculate the future percentage growth. Record your projections at the bottom of the graph.

Interpreting the Results

By now, you should have filled the Page 1 graph with a multitude of lines, points and annotations, and you can see why using colored pencils may be helpful! But a picture is worth a thousand words, and you should now have a good overview of the company you are studying. Has growth been very rapid, or slow and steady? Are there periodic dips in EPS that indicate the company may be in a cyclical industry? Have EPS and Revenues grown at a consistent rate, or are Earnings growing faster than Revenues, indicating an increasing profit margin but hard to sustain over the long term? Has the stock's price kept pace with the company's growth over the years?

You can also calculate future EPS mathematically based on your revenues projection. NAIC calls this the "Preferred Procedure" because it can provide a more accurate EPS figure, since Revenues are typically more consistent than earnings for most companies. You can see a more complete tutorial about using the Preferred Procedure.

Your decision about the company's future growth is one of the most important judgements you need to make to use the SSG properly. Having made your projections, you can now turn to Page 2 of the SSG.

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