The Wise Men of Wall Street tell us all the time that investing in stocks is "risky." Of course, it's not so risky that they don't want us to do it; they just would rather we not do it ourselves. Instead, we're to quietly hand over our money, but leave the picking to the professionals, who, on average, underperform the market year in and year out.
The problem is, when you hire professionals, you pay through the nose for their services -- generally about 1% to 2% of your entire investment. Got $10,000 to invest? One hundred dollars to $200 may not seem like an unreasonable fee. But when you're investing something closer to $100,000 or so, that 1%-2% fee is going to start to hurt . And if like most money managers, your advisor underperforms the S&P 500, that's just adding insult to financial injury. If you're a small investor, working to build a nest egg for your retirement or your kids' college fund, wouldn't you rather beat the market handily and pocket that 1%-2% annual commission rather than hand it over to the suits at Citigroup (NYSE:C) or JPMorgan Chase (NYSE:JPM)?
We sure would. And we have. At The Motley Fool's premier small-cap investing newsletter, Hidden Gems, we've managed to guide our members to a combined 43% return over the 19 months since we first started this service. That's 27% annualized and better than twice the performance of the S&P 500 over the same time period.
What's more, we encourage our members to research stock ideas themselves -- and to that end, every month we reveal a new lesson on how to find bargain-priced stocks, so that if you've got a hankering to go prospecting on your own, you'll have the tools you need to succeed.
In that spirit, today I offer up my own personal favorite tool. I call it the "7 Steps" to finding prospects. While it's not a surefire find-all for picking winners, I've found these steps do provide a basic, if not exhaustive, picture of how a business is doing. Best of all, the whole process takes only about five minutes to complete.
One gem that's still hidden
Education is great, but it's most useful when applied to something concrete, right? So, today let's apply the "7 Steps" to a particular stock -- one we unearthed long ago but whose business has grown fast enough that it remains a bargain today, despite rising 10% in price since we first found it. The company is CNS (NASDAQ:CNXS), maker of the Breathe Right nasal strips that are all the rage among flu sufferers and NFL linebackers alike.
Eight numbers and the 7 Steps to understanding them
The first step in analyzing any company is to identify its stock ticker. Luckily, the Fool makes this easy. Click here, type in the name of the company ("CNS, Inc."), and voila! A list of likely matches will pop right up. Click around them until you find the one you seek (CNXS, 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. (At this point, I suggest opening a separate window for the Yahoo! site, so you can easily see where the following numbers come from.)
On the company's Yahoo! page, you will find all of the information you need to determine CNS's
- Market cap
- Enterprise value to free cash flow
- Historical earnings growth
- Projected earnings growth
- EV/FCF/G
- Return on equity
- Insider ownership
Market cap
The site gives this to you right up front, in the top line of the center column: "172.18M," or $172.18 million (these numbers may vary slightly, depending on when you read this 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: $121.55 million.
Next, free cash flow (cash from operations 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: $12.85 million.
Divide the enterprise value (EV) by the free cash flow (FCF) and you've got your first important metric: EV/FCF = 9.5.
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 CNS, shows that over the past five years, the company has increased its profits by an average of 125.9% per year, every year. Pretty impressive. But no company can keep that kind of performance up for long. So let's look at what analysts expect the company can manage.
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 four analysts who cover CNS. On average, they expect the company to increase its profits by 15% every year over the next five years.
EV/FCF/G
We already know CNS's EV/FCF, which 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. The metric for valuing that growth potential is the EV/FCF number we worked out above divided by the company's estimated growth.
You can calculate a company's EV/FCF/G based on either the historical or the projected growth rate. Personally, I try to err on the side of caution and pick the lower number. 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 Amazon.com (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
Sometimes analysts make mistakes. So, to "quality check" analysts' predicted earnings, I like to confirm that the expected growth is not too far off from a company's recent experience in generating profits. To do this, go back to the original Yahoo! page and look at the center column, third bolded category ("Management Effectiveness"), second line under the category: Return on equity (ROE) for CNS over the last 12 months ("ttm") was 11.33%. That's a heckuva lot less than the 125.9% past-five-years' growth that CNS has posted. It's even small compared to the 15% predicted growth. In circumstances like this, to be conservative, I would substitute an EV/FCF/ROE calculation for an EV/FCF/G.
Result: CNS scores an EV/FCF/ROE of 0.84, despite its EV/FCF/G of 0.63.
Insider ownership
This is another easy one. 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 19.01%.
And one more test, for extra credit
However bargain-priced a company may be, if its management gives all the profits away to insiders, I want no part of it. So if you've found a company that still holds your interest after passing the first seven tests, go ahead and run one more -- check on its record of share dilution. While Yahoo! does not provide this information, the SEC does.
Find CNS's 10-K form on the SEC's site, and scroll down to the Consolidated Statements of Operations on page F-2. In the last line of that page, you will find the numbers of diluted shares outstanding over the past three fiscal years. Divide the March 2004 number by the December 2001 number (14,488/14,431), then take the square root of the result and this will give you the average annual rate of stock dilution over the past two years: 0.2%.
Now that you know where to find the numbers that count, come back next week for a few thoughts on which numbers qualify as "passing grades" in this seven-step test. In the meantime, take a free trial of Hidden Gems and see what other diamonds we've found a-lying in the rough. There's no charge for the trial, and you can cancel anytime, with absolutely no strings attached. You have our word on it.
Fool contributor Rich Smith has no position in any companies mentioned in this article. The Motley Fool is investors writing for investors.
