Adding Judgment
to Your SSG
Rich Beaubien
San Francisco Bay Area Chapter
Rich Beaubien
Vice President of Investment Club Products
ICLUBcentral (www.iclub.com)
[email protected]
Warning!
Judgment
This program is unusual.
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)
When it comes to selecting
good companies to invest in,
your Good Judgment is as good
as any professional analyst!
We will cover the most important parts of SSG
analysis: Sections 1 & 2
Good Luck!
Adding Judgment to Your SSG
Rich Beaubien, ICLUBcentral Inc
How do you gain confidence in
your Good Judgment ?
Practice!
Practice!
Practice!
What is Good Judgment ?
Good judgment comes from experience,
and a lot of that
comes from bad judgment.
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.
The SSG Provides the answers
to two questions….
• 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.
Adding Judgment to Your SSG
Rich Beaubien, ICLUBcentral Inc
The SSG Provides the answers
to two questions….
Adding Judgment to the Front
ALWAYS plot
º Sales
º PTP
º EPS
º price above the EPS!
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
• 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
Adding Judgment to the Front
• Straight, parallel trend lines for historic
Sales 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.
Adding Judgment to Your SSG
Rich Beaubien, ICLUBcentral Inc
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 Sales
and EPS growth
• NEVER project future EPS growth to
be greater than future Sales growth.
• Earnings come from Sales and, over
the long haul, Earnings growth will not
exceed Sales 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
Section 2A- Pre-tax Profit Margin
The 2A formula is
Pre-tax Profit divided by Sales
The 2A formula is
Pre-tax Profit divided by Sales
• 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
Adding Judgment to Your SSG
Rich Beaubien, ICLUBcentral Inc
Section 2A- Pre-tax Profit Margin
Sales
- 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
Sales, 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
Section 2A- Pre-tax Profit Margin
Sales, Cost of Goods and
Overhead move PTP
• How Can Sales 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
Quality management increases
pre-tax profit margin (% ptp/sales) by
maximizing sales while minimizing
the cost of goods sold and their
expenses
• How Can Overhead Decrease ?
• Decrease salaries, rent, advertising
Adding Judgment to Your SSG
Rich Beaubien, ICLUBcentral Inc
Section 2B- Return On Equity
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
Section 2B- Return On Equity
Net Profit
Equity
Section 2B- Return On Equity
The 2B formula is
EPS divided by Book Value
Why is EPS/Book Value called ROE ?
It’s the same as:
Section 2B- Return On Equity
Net Profit
Sales
=
Sales
Total Assets
Net Profit
X
X
Total Assets
Equity
Sales
Net Profit
Equity
= Net Profit Margin
Sales
= Asset Turnover
Total Assets
Total Assets
Equity
Adding Judgment to Your SSG
Rich Beaubien, ICLUBcentral Inc
= Financial Leverage
Section 2B- Return On Equity
Net Profit
Sales
= Net Profit Margin
Net Profit is “The Bottom Line”
(Remember to get to EPS we just divide by
shares outstanding)
Section 2B- Return On Equity
Total Assets
Equity
Section 2B- Return On Equity
Sales
= Asset Turnover
Total Assets
Asset Turnover is the amount of sales
generated per dollar of assets.
Section 2B- Return On Equity
• The company can increase ROE by
increasing any of the following:
= Financial Leverage
• Net Profit Margin
• Asset Turnover Rate
• Financial Leverage
Financial Leverage can increase
ROE, but watch out for high debt to
equity ratios!
• Basically, PTP shows that a company
earned money, and the ROE variables
show you how!
Adding Judgment to Your SSG
Rich Beaubien, ICLUBcentral Inc
Section 2B- Return On Equity
• Net Profit is “The Bottom Line”
(Remember to get to EPS we just divide by shares
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
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!
Preferred Procedure
The Calculation
Revenues x % Pre-Tax Profit on Sales = Pre-Tax Profit
• 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 "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").
Adding Judgment to Your SSG
Rich Beaubien, ICLUBcentral Inc
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
• 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
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
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?
Adding Judgment to Your SSG
Rich Beaubien, ICLUBcentral Inc
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.
The SSG is not an end,
but a beginning
• Further research is ALWAYS needed.
• The SSG asks no questions about the
company's
º
º
º
º
balance sheet,
products, or
Competitors products,
the industry the company operates in.
• NAIC's Official Guide says we must make
our own analysis that the company is
"financially sound".
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
Your Club should require a 15-20 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.
Adding Judgment to Your SSG
Rich Beaubien, ICLUBcentral Inc