Rich Beaubien. Adding Judgment to Your SSG. Warning! Judgment. Adding Judgment to Your SSG Rich Beaubien, ICLUBcentral Inc.

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1 Adding Judgment to Your SSG Rich Beaubien Rich Beaubien San Francisco Bay Area Chapter Vice President of Investment Club Products ICLUBcentral ( Warning! This program is unusual. Judgment I expect you to know how to complete an SSG. We have more than material than I can possibly cover here. So this will be highlights of a class that is done in 2 hours (it really should be 3) We will cover the most important parts of SSG analysis: Sections 1 & 2 When it comes to selecting good companies to invest in, your Good Judgment is as good as any professional analyst! Good Luck!

2 How do you gain confidence in your Good Judgment? Practice! Practice! Practice! Practice Makes Good Judgment Understanding the ramifications and requirements of the judgments you make. Know WHY you might choose certain numbers. Know WHAT has to happened. Being comfortable and confident in your analysis. What is Good Judgment? The SSG Provides the answers to two questions. Good judgment comes from experience, and a lot of that comes from bad judgment. First, Is the management good? Secondly, Is the stock fairly priced? If the company passes both tests then we accept it as a candidate for purchase.

3 The SSG Provides the answers to two questions. We will deal with the first question here Is the management good? If the company has poor management then we do not want to own it at any price. Adding Judgment to the Front ALWAYS plot º ºPTP º EPS º price above the EPS! Adding Judgment to the Front Adding Judgment to the Front First look at outliers - data that is way too high, or way too low - don t let it affect the calculation of the historical growth rates in an adverse way! Determine the historical growth rates for EPS and Revenues Straight, parallel trend lines for historic and EPS. A minimum of 15% annual growth. No wavy, choppy or otherwise erratic trend lines. Especially true for the last 5 years of the company s data.

4 Adding Judgment to the Front To project future growth look at recent historical trends by examining the last 10, 7, 5 and 3 years of historical and EPS growth NEVER project future EPS growth to be greater than future growth. Earnings come from and, over the long haul, Earnings growth will not exceed growth. Section 2 - Management Everybody knows that Section 2 is used for evaluating management, but do you understand WHY? Let s look at the numbers behind the numbers! Section 2A- Pre-tax Profit Margin The 2A formula is Pre-tax Profit divided by Section 2A- Pre-tax Profit Margin The 2A formula is Pre-tax Profit divided by Look for and upward trend in PTP margin and a higher number than the industry average Check that PTP is increasing in line with revenues and EPS! Because the PTP margin is a ratio, the margin can go UP even though PTP is going down! This is why we plot PTP on the front of the SSG

5 Section 2A- Pre-tax Profit Margin - Cost of Goods Sold Operating Margin (Gross profit before expenses) - Overhead (Salaries, Rent, etc.) Pre-tax Profit - Taxes Net Profit /Shares Outstanding = EPS Section 2A- Pre-tax Profit Margin, Cost of Goods and Overhead move PTP How Can Increase? Create more outlets - expand your territory Take market share from competitors Increase the price of goods sold Good management produces a superior product which commands a higher price! Section 2A- Pre-tax Profit Margin, Cost of Goods and Overhead move PTP How Can Cost of Goods Decrease? Economies of scale - produce more and therefore get supplies for less Increase efficiency and productivity How Can Overhead Decrease? Decrease salaries, rent, advertising Section 2A- Pre-tax Profit Margin Quality management increases pre-tax profit margin (% ptp/sales) by maximizing sales while minimizing the cost of goods sold and their expenses

6 The 2B formula is EPS divided by Book Value Again, we look for an upward trend, and the number to be larger than the industry average - The Official Guide recommends looking for companies with an ROE - 20% or greater - 15% is a good target The 2B formula is EPS divided by Book Value Why is EPS/Book Value called ROE? It s the same as: Net Profit Equity Net Profit Equity Net Profit X = X Equity Net Profit Equity = Net Profit Margin = Asset Turnover = Financial Leverage

7 Net Profit = Net Profit Margin = Asset Turnover Net Profit is The Bottom Line (Remember to get to EPS we just divide by shares outstanding) Asset Turnover is the amount of sales generated per dollar of assets. Equity = Financial Leverage Financial Leverage can increase ROE, but watch out for high debt to equity ratios! The company can increase ROE by increasing any of the following: Net Profit Margin Asset Turnover Rate Financial Leverage Basically, PTP shows that a company earned money, and the ROE variables show you how!

8 Net Profit is The Bottom Line (Remember to get to EPS we just divide by shares outstanding) Asset Turnover is the amount of sales generated per dollar of assets. Financial Leverage can increase ROE, but watch out for high debt to equity ratios! Adding Judgment to the Front Now we ve got an understanding of how management is doing, let s make our informed future growth rate projections Is there a reason why the company should meet or beat the historical averages? Is our EPS figure realistic? Let s check it with the Preferred Procedure! Preferred Procedure The Calculation Revenues x % Pre-Tax Profit on = Pre-Tax Profit Preferred Procedure The "Preferred Procedure" is a method of projecting future earnings per share (EPS) of a stock. Pre-Tax Profit x (1 - Tax Rate) = Net Profit (after tax) (Net Profit - Preferred Dividends) = Est. EPS # of Shares Outstanding The NAIC recommends that investors always use the Preferred Method to calculate future Earnings Per Share when completing the Stock Selection Guide (hence the nomenclature "Preferred").

9 Preferred Procedure The Preferred Procedure usually provides a higher measure of accuracy than trend line projections for two reasons: It is usually easier to discern a historic trend from the company's past Revenues growth, and thus project what the future growth rate may be. You can apply separate judgements for each of the variables in the calculations. Preferred Procedure Five different figures are used in this calculation Revenues Percent Pre-Tax Profit (also known as profit margin) Tax Rate Preferred Dividends Number of Shares Outstanding For each of the above five year projections have to be made. Preferred Procedure Three of the five variables, tax-rate, preferred dividends and number of shares outstanding, usually will not change very much over five years, unless something dramatic happens. Preferred Procedure Two of the five variables, will need to be assessed and five year projections will have to be made. - Revenues Five year revenue projections can be taken from the trend line drawn in Section 1 Visual Analysis of the SSG. Or an analyst estimate. - Percent Pre-Tax Profit Compare the figures for the ten years, as well as the calculated average for the past five years. Is there a trend? What seems like a reasonable figure? Is there a reasonable median figure?

10 Preferred Procedure Experienced investors always use the Preferred Procedure to doublecheck the Earnings Per Share projections on their SSG s. Often, the Preferred Method will reveal that the projected earnings per share determined by the trend line may be overly-optimistic, and should be adjusted to reflect a more realistic expectation. Small differences can have a major impact on your SSG Try out different "what if" scenarios º ALWAYS try to do a SSG that uses optimistic assumptions º ALWAYS try to do a SSG that uses optimistic pessimistic assumptions. Then decide what is more realistic... which is often some-place around the middle. The SSG is not an end, but a beginning Further research is ALWAYS needed. The SSG asks no questions about the company's º balance sheet, º products, or º Competitors products, º the industry the company operates in. NAIC's Official Guide says we must make our own analysis that the company is "financially sound". The SSG is not an end, but a beginning Your Club should require a minute presentation that includes: (A) a current SSG; (B) a discussion of the company s annual report as well as research about the company; and (C) a Stock Comparison Guide that reviews two other companies, - one of which must be a direct competitor of the company under consideration.