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7 Steps to Finding Gems

Two weeks back, we looked at a few of the most useful, and easy-to-find, metrics for quickly getting a handle on a company's investment potential. Running those down once more, they are:

The first six figures can be easily discovered with a bit of clicking around Yahoo! (Nasdaq: YHOO  ) Finance's website. The last one, share dilution, is a little harder, but you can work it out without too much trouble from information on the SEC's FreeEdgar site.

Now, veteran investors may argue that there are other metrics that give an even better picture of a company's financial condition. I agree completely. For instance, Tom Gardner developed structural free cash flow as an invaluable tool for measuring a small-cap company's true cash-generating power, and uses it almost exclusively when researching companies for each month's issue of Motley Fool Hidden Gems. Return on invested capital (ROIC) is another great tool, and one that becomes especially useful when you need to analyze a company with a heavy debt load.

But while I admit that there are other, more math-intensive, metrics available, to borrow a phrase from Henry David Thoreau, I prefer to "simplify, simplify." After all, there are over 8,000 small-cap companies currently trading in the United States. The simpler and more efficient your tools, the faster you can dig through this gigantic corporate gravel pit and find the real gems. We cannot afford to get distracted by moss-bound boulders of the Lucent (NYSE: LU  ) variety, or to waste time picking at profitless specks of fool's gold such as Xybernaut (Nasdaq: XYBR  ) -- there is real work to be done here. On that note, here is my five-minute drill for quickly sizing up whether a given company is a possible gem -- or just a hunk of rock.

Market cap
Gems come in all sizes. But let's face it, if you want to buy yourself something the size and quality of the Hope Diamond, or its equivalent in stock market terms -- say, eBay (Nasdaq: EBAY  ) -- it's going to cost you a whole lot more than that pair of quarter-carat diamond studs you picked up for mom's birthday on (Nasdaq: OSTK  ) . At Hidden Gems, we look to buy in the Overstock range, comfortably priced for any budget at a market cap between $100 million and $2 billion.

Enterprise value-to-free cash flow
Personally, I use market cap as only a rule of thumb. In truth, when I look at a company for the first time, my eyes go right to the enterprise value and free cash flow numbers. So for instance, when a few months back I found toymaker Hasbro (NYSE: HAS  ) selling for an EV/FCF ratio of 7.0, the fact that its market cap was $3.5 billion did not stop me from buying.

Ascribe it to the inner cheapskate in me. Sometimes I just cannot resist a bargain. While I might balk at paying $30,000 for a new Chevy pickup -- if I should luck out and find a 2002 model selling for ten grand at CarMax (NYSE: KMX  ) some day, I may not be able to resist the urge to buy (but only if it's a stick shift -- some standards you just cannot compromise).

In other words, I want my small caps to sell at bargain-basement prices. An EV/FCF ratio of 10 or less gets my attention real quick. Anything pricier than that, I need to take a good hard look at the company's growth rate and EV/FCF/G ratio.

Historical and projected earnings growth rates
All I want to say about growth rates is that you should always go with your most conservative guesstimate. Because yes, whether you are a professional analyst, a serious individual investor, or a newcomer to investing, when it comes to the future, we are really all just guessing.

So if over the past five years your potential gem has increased earnings at an annualized rate of 10%, but a couple of anonymous "experts" say that over the next five years, the company is going to earn 45%, well, I just advise that you err on the side of caution.

Picking a conservative growth rate estimate is crucial because of the huge effect it has on your EV/FCF/G calculation. A company with an EV/FCF of 30 might look like a classic value play, in the Benjamin Graham, The Intelligent Investor sense of yielding a 0.66 ratio when you use 45% as your growth estimate. But tread warily, dear Fool. If the company actually continues to churn out growth of only 10%, you will find you have bought yourself one terribly overvalued stock.

As for the number I like to emerge from my EV/FCF/G calculation, I find a nice, round 1.0 quite appealing. On the one hand, I like the number because it offers a Graham-sized margin of safety to the market's current EV/FCF/G ratio of roughly 1.5. On the other, I like it because, in my experience, companies with EV/FCF/G ratios of 1.0 tend to double in value in relatively short order. Sadly, they usually do this while I am still sitting on the sidelines, hoping they will get just a little bit cheaper before I buy (a habit I am trying to break).

Return on equity
If the uncertainty and guesswork involved in estimating a company's earnings growth potential makes you a little queasy, consider a more definite method that many Fools have been experimenting with -- and run an EV/FCF/ROE calculation instead. The math is just as easy, and the principle is pretty much the same: you want the EV/FCF valuation to be lower than the company's return on equity -- the number that measures how efficiently the company invests in its own business. As with EV/FCF/G, the bigger the denominator (ROE), and the tinier the result of the full calculation, the better. (In other words, 1.0 is good. 1.5 or more is bad.)

Insider ownership
This one is both straightforward and tricky. The more insider ownership, the better -- up to a certain point. If company officers, directors, etc., own a significant stake in a company, they have a strong incentive to run the company well, use company funds efficiently, and keep a tight leash on share dilution. On the other hand, if insiders own too many of a company's shares, they effectively have control over the business and can run it any dang way they like. Personally, I like to see double-digit insider ownership, say at least 10%, but no more than 50%.

Share dilution
Read my lips: no new shares. Period. I hate share dilution with a vengeance that borders on rabidity. Companies that dilute minority shareholders at double-digit rates will not receive the benefit of my investing dollars under any circumstances. Share dilution of 3% or less will win my (grudging) approval, but only if all the other numbers look good.

And there you have it, folks. My seven-step program to finding potential small cap winners. Give it a spin yourself, and when you think you have found a winner, share the good news on the Hidden Gems Stocks That Interest You board -- only on, and only for Hidden Gems members (but feel free to try it out risk-free with a trial subscription).

Fool contributorRich Smith owns shares of Hasbro, but of no other companies mentioned in this article. The Fool has a gem of adisclosure policy.

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  • Report this Comment On March 11, 2009, at 8:39 AM, foolishgoth wrote:

    I would love to add this to a "My Favorite Artical Section". I reread this every few years as I undertand more and more about investing and corporate structure. Each time I read it I see new layers of information.

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