Panning for Gold

We took a brief glance last week at the numbers for Maryland clothier JoS. A. Bank (Nasdaq: JOSB  ) . This week, let's delve into the mechanics of running a "high-level due diligence review" on a stock: a five-minute rundown that yields a basic, if not exhaustive, picture of how a business is doing.

High-level due diligence is especially useful when seeking the sort of unnoticed, unloved, little-followed small caps that we favor in Motley Fool Hidden Gems. There are an awful lot of tiny companies out there in the investing universe, after all. If you want to have any chance of finding the few good ones, it's invaluable to have a plan for quickly sifting through the gravel to find the real gems. That's what I hope to provide you in the next few paragraphs.

So say you walk into your neighborhood clothing store one day and find a poster by the register that reads, "Like our suits? Think they're a good value? Try our stock! It's even cheaper!"

I'm paraphrasing, but that was the gist of the pitch that JoS. A. Bank threw its customers when I first noticed the stock. And JoS. A. Bank isn't the only one using this approach. Fool alum Tom Jacobs pointed out a similar ad campaign sponsored by Washington Mutual (NYSE:WM) last year, as did Foolish professor emeritus Bill Mann, who found a separate pitch from Dominion Resources (NYSE:D)in his mailbox.

The following question might occur to you at this point:

How do I know if this is a good stock or not?
I was just getting to that. The first step, dear Fool, is to identify the company's stock ticker. The Fool makes this step simple. Click here, type in the name of the company (e.g., JoS. A Bank), and voila! A list of likely matches will pop right up. Click around until you find the ticker you seek (JOSB, in this instance).

Once you have the correct ticker symbol in hand, off you go to your favorite financial information website to do some prospecting. My favorite, for breadth of information and ease of navigation, is the Yahoo! (Nasdaq: YHOO  ) Finance site, which you will find right here. (At this point, I suggest opening a separate window for the Yahoo! site, so you can easily see from where I am obtaining the following numbers.)

If you recall, I recounted JOSB's numbers last week:

JoS. A. Bank
Market cap: $322 million
Enterprise value-to-free cash flow: Negative
Historical earnings growth: 38%
Projected earnings growth: 22%
EV/FCF/G: Negative
Return on equity: 25%
Insider ownership: 19%
Share dilution: 9.3%

Note: Chart numbers might differ from those posted on Yahoo! Finance because of stock price fluctuations.

Here's where we get them, one by one.

Market cap
The site gives this to you right off the bat in the top line of the center column: "322.15M", or $322,150,000. (Jos. A. Bank ran into some trouble since I wrote last week's column.)

Enterprise value-to-free cash flow
Break this down into two parts. First, enterprise value (which equals market cap plus long-term debt minus cash on hand). That's on the second line of the center column: $361,860,000.

Next, free cash flow (operating cash flow minus capital expenditures). Most financial sites make you work to find this number. One of the reasons I prefer the Yahoo! site is that it gives it to you with no math required. Look at the very last line of the center column: -$30,580,000.

That's usually as far as I would go in a high-level due diligence operation. As soon as I see negative free cash flow, I junk the company and move on to more promising investment ideas. But let's soldier on and complete the exercise anyway.

Historical earnings growth
Now you need to do some clicking. Look at the left column of the page and click on "Analyst Estimates," the second hyperlink under the bolded "Analyst Coverage" heading. Scroll to the bottom of the page, where you see a table titled "Growth Est" in bold. In the first column of that table, you will see an entry titled "Past 5 Years (per annum)." The column to the right of it, the one for JOSB, shows that over the past five years, the company has increased its profits by an average of 38% per year.

Projected earnings growth
Repeat the above steps, but this time focus on the line titled "Next 5 Years (per annum)." This one shows you the results of a poll of the eight analysts who cover JoS. A. Bank. On average, they expect the company to increase its profits by 22% every year over the next five years.

So far, we know JoS. A. Bank's enterprise value-to-free cash flow ratio (its EV/FCF, in lazy-speak). That shows the company's current valuation -- how many years it would take to pay you back your entire investment in the company, if it continues to rake in greenbacks at the same rate it is doing now, eternally.

The thing about companies, though, is that they grow (we hope). Over time, they get bigger and better at making more and more money for you every year. The metric for valuing that growth potential, the company's EV/FCF/G, is the EV/FCF number we worked out above, divided by the company's estimated growth.

Now, you can calculate a company's EV/FCF/G based on one of two growth rates: how fast it has actually increased its earnings historically, or how fast the analysts project it will grow its earnings in the future. Whether to choose the historical number or the projected number is a personal choice, but I suggest erring on the side of caution and picking whichever number is lower. Do that and you will probably miss out on investments in early stage turnaround stories, where a damaged company is poised to rebound a la (Nasdaq: AMZN  ) . But you also minimize your risk of buying into a JDS Uniphase (Nasdaq: JDSU  ) or Lucent (NYSE: LU  ) based on somebody else's rosy predictions.

Return on equity
This is another easy one. Go back to the original Yahoo! Finance page and look at the center column, third bolded category ("Management Effectiveness"), second line under the category: Return on equity for JoS. A. Bank over the last 12 months ("ttm") was 24.98%.

Insider ownership
Again, easy. Look at the far right column, second bolded category ("Share Statistics"), fifth entry thereunder. The "% Held by Insiders," or percent of all shares outstanding that company officers and large shareholders own, is 19.22%.

Share dilution
However bargain-priced a company may be, if its management gives all the profits away to insiders through share dilution, I want no part of it. Thus, the last step I take when running a stock through a high-level due diligence review is to examine its history of share dilution. Sadly, Yahoo! does not provide this information. But the SEC's FreeEdgar site does.

Once you have registered and clicked your way through to the 10-K form, scroll down to the Consolidated Statements of Income on page F-4. In the last line of that page, you will find the numbers of diluted shares outstanding as of end-of-year 2001, 2002, and 2003. Divide the 2002 number by the 2001 number (10,587 / 9306 = 1.138), then divide the 2003 number by the 2002 number (11,106 / 10,587 = 1.049). Add the two results and divide by two to get the average dilution rate over the past two years: 9.3%.

And that's how it's done. I'll be back soon for a few thoughts on what kinds of numbers qualify as "passing grades" in a high-level due diligence review.

There are only four days left until the Hidden Gems price increase. Here's how you can lock in at low charter subscription price.

Foolish contributorRich Smithowns no shares in any of the companies mentioned in this article. The Fool has a stringentdisclosure policy.

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Rich Smith

As a defense writer for The Motley Fool, I focus on defense and aerospace stocks. My job? Every day of the week, I'm monitoring the news, figuring out the winners and losers, and tracking down the promising companies for you to invest in. Follow me on Twitter or Facebook for the most important developments in defense & aerospace, and other great stories.

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