Introducing the Great Companies Fundamental Analyzer

These valuable tools are offered to assist the serious long-term investor in making sound long-term investment decisions.  They are based on sound principles of businesses, economics and accounting. The core premise behind them is the recognition and understanding that the worth of a business can be calculated and known.  Fundamentally, in the longer run an operating company's worth is directly related to the future stream of revenues, cash flows and ultimately the earnings it can and will generate for its shareholders. The most important determinant of the company's value is the rate of change or velocity of the revenue stream.  Simply  stated, a company with a faster growth rate is worth more than a company with a slower one. 

Not only is this based on common sense, it is also conclusively verifiable by examining the historical correlation and functional relationship between a company's valuation (PE Ratio) and its stock price over time.  Our historical graphs clearly illustrate this important dynamic. This insightful relationship can be expressed as a simple mathematical formula that is uncannily accurate and relevant in the vast majority (but not all) of companies.  This general rule of thumb formula is as follows: A company's fair value is equal to a PE ratio that is equal to its earnings per share growth rate.  (Value = PE = EPS Growth Rate).  In other words, a company growing at 10% a year is worth 10 times earnings, a company growing at 15% a year is worth 15 times earnings, a company growing at 20% a year is worth 20 times earnings and so on.

The importance for a true investor of understanding this principle is most profound.  An investor armed with the insight is empowered to know precisely what price or valuation they should be intelligently willing to pay for a share of a company's common stock.  They know that if they pay more they are overpaying, therefore diminishing their appropriate potential for an adequate return while simultaneously increasing their risk.  This principle is even more powerful when the market provides the opportunity to pay less.  When this occurs their acceptable return is increased and their risk is lowered by the bargain price.

We did not invent or discover this profoundly important principle of valuation.  Rather, we learned this by studying the investing practices of the most brilliant and successful investors of all time.  Men like Ben Graham, Warren Buffett, and Peter Lynch have shared these principles with all who would listen.  These master investors have undeniably proven the veracity of these sound-investing practices in the real world documented superior long-term results they created for their investors. As we entered the investment management business, it seemed only sane and logical to study the habits and behaviors of the investors that created the best records for their clients over the longest periods of time.  It never ceases to amaze us how few investors follow their lead. 

Amazingly, most professional managers and even more bizarrely the entire academic community seem to ignore the lessons of these investing greats.  Consequently, we found almost nothing offered by mainstream financial service providers or the educational community to help the serious investor.  Therefore, we had no choice but to develop our own.

We offer our fundamental charts and graphs as tools to assist the fundamental investor in making sound long-term decisions and as a tribute to our mentors.

top of page

Tools To Think With

It is important to point out that our charts are materially different than the standard charts typically found on Wall Street.  First of all, our charts are based on sound fundamental analysis.  This is in stark contrast to so called technical charts that claim to tell you where the price of a stock will go in the short-run.  It is our view that no chart or trading system is capable of doing this.  Short-term stock price movements can be and mostly are quite random and even irrational. 

Trying to guess their immediate movement or direction more often than not produces disappointing results.  Market timing simply does not work.

The Great Companies Fundamental Analyzer on the other hand assists us as long-term prudent investors in determining a company's fair or reasonable value.  Armed with this vital information,we are better capable of making sound long-term investment decisions.

In short, our fundamental charts are offered as tools to assist the investor to think with.  This is analogous to a surgeon's scalpel.  It is the surgeon and his skill that performs the successful operation, the scalpel is merely the instrument that he uses. 

Our charts, like the surgeon's scalpel, are valuable in direct proportion to the skill and mastery of the user.  Fortunately, our charts are much easier to learn to use than a surgeon's scalpel.  However, they can be just as important to the investor as the scalpel is to the surgeon.

To clarify, our charts are not designed or offered to tell where the price of a stock may go in the short run (3 years or less); in fact no chart is capable of doing that.  Their importance is much more valuable regarding wealth creation than short-term market timing.  Our charts help the serious investor assess the realistic, reasonable and proper value or valuation that a business being contemplated for purchases is worth. To quote Warren Buffett: "There are only two things an investor needs to know, how to value a company and how to think about stock prices."  The EDMP fundamental charts elegantly help answer both important questions.  When you have a sound basis and understanding of what a business is worth, you can then determine whether the current price quote represents overvaluation, undervaluation or fair value.  Armed with this powerful perspective, sound long-term investing decisions can be made.

top of page

Easy to Learn, Easy to Use

Unlike technical charts, the Great Companies Fundamental Analyzer is easy to learn and easy to use because it is based on common sense principles.  In essence, it provides a clear and simple visual presentation of vital financial information.  Don't, however, let their simplicity mislead you.  They are powerful and profound tools that greatly facilitate the investing process.  If used properly, they can significantly reduce investment risk while simultaneously enhancing and ensuring an above average long-term return on your equity investments.

The EGreat Companies Fundamental Analyzer is also as flexible as it is powerful. For example, it can be used as a quick and effective screening tool to separate the wheat from the chaff, or as an indispensable adjunct to a thorough analysis of a company or industry.  It can also adapt and prove valuable to different styles, such as value, growth or contrarian, etc.  However, it should be noted they were designed to aid the value/growth (GAARP) or business perspective investor.  Therefore, in their purest form, they serve as a foundation and or adjunct to serious research and thorough analysis. We would never advocate using our charts and graphs alone in making investment decisions.  Although, a case could be made that there exists many strategies or investing techniques and schemes that are commonly used, though less effective or profitable.  Our charts are most useful when integrated into and used in conjunction with a thorough research process.

top of page

The Logic Behind Our Graphs

We believe that true investors intuitively realize that there is and has to be a relationship between a publicly trading business' operating results and its stock price over time.  The more successful the business is, the higher the stock price will rise.  True investors also realize, that in the short run, stock prices can behave quite randomly and irrationally.  The volatility in a company's stock price over a calendar year time frame can often be extreme.  In other words, a company's stock price can vary by 50% or more with common sense dictating that the business' true worth could not possibly differ that much in such a short time. Obviously, something other than operating results drives market prices in the short run.  There are many factors that can cause this aberrant behavior.  Most commonly this occurs when emotion over takes reason and judgment.  Various degrees of fear, greed or perhaps speculative fever can and will rule in the short run.

The well-grounded serious investor understands these as anomalies that cannot be sustained.  Time is the great equalizer and the longer the time frame the more rational the market behaves.  You can prove this to yourself by creating up to twenty years of historical results through our fundamental chart program. Furthermore, aberrant irrational behavior cannot be forecast, therefore true investors waste little time with such nonsense. True investors focus their attention on understanding and evaluating the business and its prospects for generating future revenue streams.  They establish a realistic and reasonable valuation, which then becomes their benchmark.  Knowing what the business is worth empowers them to exploit other's folly.

The most successful investors avoid allowing other's short-term buying or selling behavior to taint their view of a business.  True investors are well grounded because they have done their homework, understand their businesses and have a solid sense of what those businesses are worth now and in the future. 

We believe this is precisely what Warren Buffett means when he talks about how to think about stock prices.  We believe our charts greatly facilitate this rational process.

top of page

Vital Questions Answered The most salient feature and benefit of the Great Companies Fundamental Analyzer is its ability to aid in answering vital investing questions.  When used properly, these charts save us a significant amount of time and effort.  There are critical fundamental questions that a true investor must successfully answer.  The Great Companies Fundamental Analyzer does this most efficiently.  It is never wrong for investors to be rational, prudent and realistic when making financial decisions. The most important questions that investors need to answer can be broken down into two groups: Primary and Secondary.  Warren Buffet eloquently gave us the primary questions of which there are only two.  The first primary question is:  How to value a company?  The second primary question is:  How to think about stock prices?  The secondary questions of which there are many simply key off the primary ones. We believe the most effective way to learn how to use this powerful tool and appreciate their profound investing value is through a step-by-step process.  In other words, let's raise each question and use the Great Companies Fundamental Analyzer features to answer them.  We will use real life examples throughout this tutorial, starting with the simplest, most straightforward and moving to the more complex and challenging to analyze. It's important to remember that these tools are most valuable and effective when used in conjunction with thorough research.  However, one of their most efficient virtues is when they are initially utilized to identify whether a company is worthy of the research effort or not.  In other words, they are very effective screening tools, therefore avoiding much wasted time and effort. Another important tip before we get started is to open your mind and accept how straightforward and simple these charts really are.  Don't complicate the process; the power lies in their ease of use.  With that said, let's use the tools and do some analysis. Our first example company will be Schering-Plough.  We chose it because as you will see, it represents the perfect example of a consistent growth company.  If you are already knowledgeable about Schering-Plough, you will discover an enlightened perspective regarding its future investment merit.  If you are not familiar with the company, you will experience the power and value of these charts as a screening tool.  In either or both cases, you will begin a most valuable investor learning process. The Great Companies Fundamental Analyzer is actually many charts in one tool.  The first two deal with the company's history and the third with its future.  The first historical chart provides a visual representation of the company's fundamental operating results for up to 20 years.  The second gives you the company's track record to include dividends for each historical period selected.  All three chart sections offer answers and insights to the two primary questions: 1.  How to value a company?  2.  How to think about stock prices?  We will first cover the historical parts, then our forecasting parts later. EDMP Historical Charts We will start with primary question number 1.  How to value a company?  We will use the charts to answer this primary question through a step-by-step process of asking and answering the obvious and related secondary questions one by one.  The basic principle behind this exercise is to test the primary premise of value.  As you recall, our formula for value is as follows:  Value = Price Earnings (PE) Ratio = Earnings Per Share (EPS) Growth Rate. First secondary question:  What has the company's historical Earnings Per Share (EPS) growth rate been? Answer: We multiply each year's earnings per share (EPS) by the growth rate 18.5% (Schering-Plough Example) by marking on the graph with a triangle () then connecting the triangles () to create our earnings growth rate line (theoretical value).  Using the vertical price scale on the left, our value line represents the theoretical worth or value of Schering-Plough for each year or any point on the earnings growth rate line.  The earnings growth rate line also represents a PE ratio equal to the growth rate for the entire fifteen-year period. Second secondary question:  Is there a correlation and relationship between the company's operating results (earnings growth rate line) and its stock price over time? Answer:  To answer this question, we add the company's monthly closing stock prices for the 15-year period to the graph. (Our chart program allows you to create this chart for up to 20 years if available). In our Schering-Plough example, any time the price touches the earnings growth rate line, it is trading at 18.5 times earnings or a price earnings ratio (PE) of 18.5.  Obviously, if the price is above the earnings growth rate line, it has a price earnings ratio (PE) higher than 18.5 and vice versa. In this example, for the first eight years at least, Schering-Plough's stock price has clearly followed its operating results or earnings per share (EPS).  Please note the apparent anomaly or aberration from our value formula starting in 1997.  This will be separately explained later when we answer primary question 2:  How to think about stock prices? Third Secondary Question:  How consistent and reliable has the company's earnings growth been? Answer:  This information is provided at the bottom of the graph by examining the numbers marked as Change/Yr or the company's annual growth rate of earnings.  These are the smaller print numbers expressed as a percentage and found just under each year's earnings per share (EPS) number and just above the year's dividend (DIV). Simply stated, the Change/Yr information tells you the percentage change of earnings growth the company achieved from each previous year to the next.  For example, Schering-Plough earned $.26 in 1989, which grew to $.32 in 1990.  By looking under the $.32 we see that this was a year-to-year growth rate of 23.1%.  A quick scan of the Change/Yr results for Schering-Plough show a remarkably consistent rising stream of earnings growth at double-digit rates. Fourth Secondary Question:  In addition to consistency, is the company's earnings growth rate accelerating, decelerating or remaining the same? Answer:  Again, we look to the Change/Yr data for this important insight into the company's operating performance.  In our Schering-Plough example, there has been a pattern of accelerating growth since 1996 of 15.5% to 1997 of 19.5% and finally to 1998 of 22.4%. There was growth in earnings after that time, but less of an acceleration. One could conclude, however, that each of these results are within a reasonable variance of Schering-Plough's 15-year average growth rate of 18.5% and that a general pattern of slight accelerations and decelerations from the norm are both common and understandable.  Nevertheless, in Schering-Plough's case, we have at a cursory level of analysis a very well managed and consistently growing company.  This is obviously an excellent characteristic for a company one would consider adding to their long-term portfolio, as long as it could be bought at a reasonable price or valuation. Fifth Secondary Question:  What is the company's track record (to include dividends)? Answer:  If you click on the View/Print 15 Year Performance History above the 15-year chart, the system shows the company's track record chart similar to the following.  Hint: You may also check the box in the left control panel labeled "Performance", which will automatically show a performance grid below each company you chart. This record is calculated from the first closing month price-to-current month closing price valuation. For ease of calculation a beginning $10,000 investment is assumed for each company.  Dividends are included but not reinvested. SCHERING-PLOUGH(SGP)   15 YEAR PERFORMANCE RESULTS     Amount Invested:   $10,000.00 Closing Value:   $156,048.46     Split-adjusted Price(12/31/1986):   2.47 Closing Price(04/30/2001):   38.54     Dividend Cash Flow     YEAR Dividend/Share Cash Dividend % Return     1987 0.06 $242.94 2.4%     1988 0.09 $364.41 3.6%     1989 0.11 $445.39 4.5%     1990 0.13 $526.37 5.3%     1991 0.16 $647.84 6.5%     1992 0.19 $769.31 7.7%     1993 0.22 $890.78 8.9%     1994 0.25 $1,012.25 10.1%     1995 0.28 $1,133.72 11.3%     1996 0.32 $1,295.68 13.0%     1997 0.37 $1,498.13 15.0%     1998 0.42 $1,700.58 17.0%     1999 0.48 $1,943.52 19.4%     2000 0.55 $2,226.95 22.3%     2001 0.63 E $2,550.87 25.5%                 Total Cash Dividends:  $ 17,248.74   172.5%     Closing Cash Value:   $156,048.46   1,560.5%     Total Value:   $173,297.20   1,733.0%     Compounded Annualized Rate of Return:   20.9%   Performance History for SGP Copyright © 2000, EDMP, Inc.  - All Rights Reserved   Using our Schering-Plough example, its split-adjusted closing price on 12/31/1986 was $2.47.  Schering-Plough's closing price on 04/30/2001 (15 years later) was $38.54; therefore turning $10,000 originally invested into $173,249 about 15 years later. Dividend income grew from $.06 per share by 1987 to an estimated $.63 per share in 2001 generating a total dividend cash flow of $17,249 or just over a return of 172% of our original outlay.  The last line on the table gives the compounded annualized return, which in Schering-Plough's case was 20.9%. You may have noticed that Schering-Plough's earnings per share growth rate of 18.5% translated into a 20.9% rate of return, and therefore is not consistent with our "stock price will follow earnings" hypothesis.  Again we will cover this when we move to answering primary question #2:  How to think about stock prices?  However, a quick glance at the chart shows the stock price of Schering-Plough, on 04/30/2001, deviates dramatically above the value line. Sixth Secondary Question:  What is the normal volatility of the company? Answer:  The answer to this important question is found on two places on our graph.  The very top of the graph lists the company's high and low price for each year.  In our example of Schering-Plough, even this model of consistency has variations from tops to bottoms of 30% to 50% in any given year.  You can also review the 15-year monthly closing price line to evaluate how jagged it is. In our Schering-Plough example, the price volatility is actually quite low. The main stream financial services industry attempts to answer this question with esoteric and even complex ratios such as beta and or standard deviation.  We hope that you can see how much more clearly and effectively a fundamental chart like ours answers and gives insights into this important characteristic.  You may even find it amusing to know that Warren Buffet has referred to the use of little Greek letters as "Dementia and Twaddle." Seventh Secondary Question:  What is the company's record of stock splits? Answer:  Just to the right of the 15-year chart we list each split and the date.  All data on the chart has been split adjusted.  Eight Secondary Question: What has been the typical or normal valuation that this company historically trades at? Answer:  You may have noticed that in addition to the earnings growth rate line there is a second earnings related line marked Normal PE Ratio.  The Normal PE Ratio line illustrates the most common price earnings (PE) ratio that the company's stock price historically trades at.  In the Schering-Plough example, its Normal PE Ratio is 21.6 or slightly higher than its earnings growth rate of 18.5%.  This deviation from our value formula (Value = PE = EPS Growth Rate) is almost totally a result of excessively over extended stock prices beginning in 1997.  You may also notice, that as a result of President Clinton's threat of health care reform in 1993, Schering-Plough, along with most pharmaceutical companies, saw its actual price earnings (PE) ratio fall below the earnings growth rate of 18.5. The Normal PE Ratio line has been added because certain companies and industries will typically trade at explainable deviations from our growth rate hypothesis.  An easy to explain example would be Phillip Morris and other tobacco companies.  Even though Phillip Morris has consistently grown its earnings per share at 15-20% per year, the market applies, in essence, a discounted price earnings (PE) multiple of typically 11-12 times earnings or a price earnings (PE) of 11-12.  This discount to growth rate valuation is caused by the extra risk and negative connotation of tobacco products.  Therefore, if you were considering Phillip Morris to invest in, you should at least be aware of its tendency to trade at a discounted multiple of earnings relative to other companies with similar operating results in more benign industries. It is also important to note that the Normal PE Ratio line will be higher than the earnings growth rate line in some instances and lower in others.  Coca-Cola and General Electric are two examples of companies that tend to trade at a premium to their growth. In most cases, earnings and stock prices are still correlated.  Furthermore, the Normal PE Ratio is related to and correlates to the earnings growth rate even when it's different than the growth rate. The important attribute of the Normal PE Ratio line is that it illustrates normal value for the respective company.  Obviously this is an important piece of information to consider before investing.  However, as previously stated, our charts are offered as tools to think with.  When examining the Normal PE Ratio, look for anomalies that may be skewing the Normal PE Ratio. Thus far we have covered the most important features and benefits of the EDMP historical charts.  Next, we will move on to our very important forecasting charts, but first a few general and summary remarks about the historical tools are in order. We would strongly suggest that the historical charts are arguably the most valuable of the charts we offer.  The argument behind this statement is based on the fact that our historical charts deal with what has already happened.  In short they are an accurate portrayal of the company's history.  Although different people with differing views could interpret the data differently, the facts are the facts.  Their accuracy comes from the compilation of known facts.  There is no conjecture or forecasting involved.  They are what they are, and what has happened has happened.  Furthermore, you will recall that we chose Schering-Plough because it was a classic example that illustrates the veracity of our core hypothesis.  Later in this tutorial we will return to the historical charts where we will take what we learned from the classic case and apply the logic to less perfect examples.  However, we are quite confident that you will find these fundamental tools to be valuable analytical tools.  Moreover, after examining literally thousands of examples we have never found an exception to the long-term relationship between a company's long term operating results and its stock price.  top of page

The EDMP Forecasting Charts

Introduction:  While our historical charts portray and prove that a company's stock price is directly related to its operating results, our forecasting charts deal with the more important future.  Obviously, it is a much different proposition to forecast the future than it is to review the past.  Therefore it is logical to assume and realize that forecasting charts cannot be expected to be as precise as our historical charts.  However they are in reality more important, because the future is where we invest.  The point is that the forecasting charts must be used more cautiously and with a more discerning eye.  Nevertheless we believe you will find them to be very powerful and profound tools if used properly.  Ask of them only what they are capable of providing and they will serve your investing needs quite well.

We will follow the same format in illustrating our forecasting charts as we have done with our historical charts.  We will continue dealing with Primary Question 1: How to value a company?  And we will continue to raise and answer secondary questions as we go.  Just as we did with our historical charts we will also provide the logic and the calculations that are used to create the charts.

A very important point to understand about our forecasting charts is that they are not a mere extension of the historical charts. The forecasting charts strive to identify with reasonable parameters what the future prospects of the business being analyzed might hold.  The future may be materially different from the past, better or worse.  It is more prudent to base your investing decisions on a reasonable expectation of the future than the past.

top of page

The Logic Behind Our Forecasting Charts

The logic behind our forecasting charts is essentially the same as our historical charts.  The primary difference is that our forecasting charts deal with estimates of the future, where our historical charts show the actual past.

The very same hypothesis used in our historical graphs is also applied to our forecasting charts.  If a company's stock price follows earnings in the past then it should logically do so in the future.  The only difference would be the future growth rate of earnings will be determinate of value, rather than the past growth rate.  More importantly, future earnings growth may differ materially, again better or worse, than future results.  Therefore, forecasting future earnings is the key.

Most publicly traded companies will have at least one, and sometimes many (40 or more) professional financial analysts following or reporting on them.  These analysts work for Brokerage firms, banks, underwriters and other major financial institutions.  Their estimates and complete reports are made publicly available through numerous sources.  The leading sources of analyst's estimates are First Call, Zacks and IBES.

The consensus earnings estimate of these leading analysts is a logical starting point in evaluating the future prospects of a company. There are several considerations however that should be factored in and contemplated regarding their accuracy.  In theory at least, the closer their forecasts are to current time the more accurate they should be. Therefore, it also logically follows that the further out they look, the murkier the picture.  This is more relevant for certain industries and companies than for others.  For example, a technology company's future prospects might be significantly impacted by a competitor's breakthrough or invention that is not even known or imagined today.  On the other hand, a basic industry such as a food company might have more predictable prospects.  Regardless, the further out you look, the less precise the forecast. 

It's also interesting to note and recognize that a material amount of the analyst's information and viewpoint comes from the management's guidance of the company being reported on.  It is typical for management to guide analysts expectations lower than they might actually believe.  This is to avoid the dreaded and damaging disappointing earnings report that most often hurts the company's stock price.  If you are going to surprise the analysts and the investors relying on them, it is generally preferable to exceed their expectations.

However, it is also important to realize the management of the companies and the analysts themselves may simply be miscalculating future prospects.

Another significant bias that often occurs relates to human nature itself.  If people are in a pessimistic mood or state, they tend to forecast the longer future more pessimistically and visa versa.  Consequently, a disinterested or not directly involved party may have a distinct advantage. In other words, if you can access and recognize this bias you may be able to exploit it to your advantage.

The critical point is that although analyst's estimates can be a useful tool, they must also be continuously reexamined and checked.  Furthermore, we also find it very useful to note whether the analyst's estimates have been trending higher or lower over the last year or so.  Each piece of incremental information that an investor can gather and analyze the better his decision making precision.

Most importantly of all, every intelligent investor should question the estimates of analysts and management.  You might learn that a particular analyst or group of analysts may have in the past and or in the future work for companies that are providing underwriting services to the company they are reporting on.

Consensus earnings estimates are a sound starting point for evaluating a company's future.  Generally they are reasonably accurate to the best abilities of the people making them, previously mentioned biases not withstanding.  However, evaluating a company's future is a process that never ends.  Change to some dome degree or another is a virtual certainty, and therefore certain diligence is necessary.  This is especially important when your money is already down.


top of page

Stock Prices Do Not Necessarily Reflect True Value

Primary Question #1: How to Value a Company?

Since there is a clear and rational relationship between a company's stock price and its long-term operating results, forecasting future results is the key to investing success.  The EDMP forecasting charts are offered and designed to assist the serious fundamental investor in forecasting future earnings.  In truth, it is impossible to precisely forecast future earnings three to five years out.  Therefore, the objective of our forecasting charts is to offer a reasonable range of probabilities for each company's future earnings.

That said; it is also important to realize that the forecasts presented are not mere guesses or hunches.  They are forecasts based on a careful assessment of all known information that can be gathered and evaluated.  Forecasting is a process of continually gathering and accessing each piece of news or incremental information as it becomes available.  Even though we know the numbers are not perfect or precise, they are still extremely valuable as long as they are based on realistic assumptions.  The skilled practitioner of our forecasting charts factors in and evaluates a sensible range of probabilities.  Most importantly, adjustments up or down are constantly being evaluated.

Forecasting Charts: Secondary Question #1.  What is the consensus three to five year estimated future growth rate of the company?

Answer:  Continuing with our Schering-Plough example, the consensus estimated growth rate is 14% and is noted to the right of the graph as Estimated Earnings Growth.  The Estimated Earnings Growth line represents our future estimated value line.  We start with the consensus estimate for the current year's earnings and any future years estimates that are available and simply grow it by the consensus three to five year growth rate.  In theory, the closer the estimate, the more reliable it is.

Forecasting Charts: Secondary Question #2: How broadly followed is the company and therefore how reliable is the consensus estimate?

Answer:  To the bottom right of the forecasting chart we list the number of analysts.  In our Schering-Plough example, there are twenty-five (25) analysts in the consensus.  In theory, the larger the number of analysts; the more reliable the data.  That is however, only a theory.

There are also several other important factors that should be examined as it relates to the veracity of the data.  Most reporting agencies (Zacks, IBES, First Call, etc.), will also list the high, low and median analysts estimate.  In our charts we use the median number, when available, otherwise; we use the mean number.

The closer the analysts' estimates are to each other, the stronger the consensus.  It could also be quite useful to evaluate the company from the perspective of the high and low estimate.  This exercise would provide a range of possibilities of the potential future value of the company.

Additionally, you should consider the recent trend, for the past year or so have the estimate been rising or following.  You may also want to consider such things as biases.  Are the analysts in a positive or negative posture regarding the company and or industry?  It would also be useful to know whether a particular analyst or group of analysts worked for firms that have or are providing financial services to the company.  The point is, like our historical charts, our forecasting charts are tools to assist you in your investing decision making process.  They should never be the only information you rely on.  They can and are, however, extremely valuable for helping you access reasonable probabilities and prospects for companies you are interested in purchasing.

Secondary Question #3: What price earnings ratio is the company trading at?

Answer:  The Estimated Earnings Growth (value line) line is the base line growth rate, and the only growth rate depicted on the graph.  The five lines above the Estimated Earnings Growth and the five lines below the Estimated Earnings Growth, represent various price earnings (PE) ratios in plus or minus 10% increments from the Estimated Earnings Growth.  To repeat, these are not different growth rates, they are "parallel" lines that represent various price earnings (PE) ratios that the company may be trading at, in reference to the estimated growth rate.



In our Schering-Plough example, the stock price is significantly higher than the top line PE ratio of 21.  When originally designed, we surmised that 50% deviations in PE ratios above or below the growth rate were extreme enough to cover all anomalies or aberrations.  Obviously we were wrong.  The current price of the stock and the date reported are listed just to the upper right-hand corner of the chart.  The current PE of 26.5 is shown just below the closing price at the upper right-hand corner of the chart. A current PE line is also drawn in red, if it is outside the plus or minus 50% spread of the other eleven lines.  The current PE in this example is well above 21 times earnings.  The obvious overvaluation of Schering-Plough's price and its ramifications will be further addressed later in the section "How to think about stock prices."

Secondary Question #4: What is the financial strength of the company?

Answer:  As already pointed out, our charts are most valuable when used in conjunction with a thorough and detailed research process.  At the bottom right hand corner of the forecasting chart, we provide the company's debt ratio.  In our Schering-Plough example, it only has 2% debt and therefore 98% equity.

This merely provides an at a glance perspective of the company's financial strength.  Low debt is generally a good thing, however, you should be cautioned that debt is not necessarily a negative.  Certain industries use or require debt as a function of their business.  Banking is a good example.

Secondary Question #5:  What is the company's current stock price, and what has its recent trend been?

Answer:  The current price of the company can be determined in two ways.  For a rough estimate you can simply use the vertical price scale on the left side of the chart.  In fact, you can see each weekly closing price by putting your mouse pointer on the black price line near a closing price. The price and date will pop up on the screen. You can see the volatility over the last calendar year through the current date.  You can also see current valuation, which is the most valuable attribute of the chart.  We will elaborate on this later in the section "How to think about stock prices."

We also list the last closing price plotted in the chart and the date of that close just off to the upper right hand corner of the chart.

Conclusion:  As you can see the EDMP forecasting charts are easy to understand and use.  In essence our forecasting chart is a five-year chart, which can be expanded up to 12 years.  There is one year of history (last year), the current year we are in and finally three forward years.  The real value and potential impact these charts have regarding long term wealth creation is their propensity to act in making sound long term buy or sell decisions.  This will be discussed in depth later in the important section "How to think about stock prices."  It's important to mention again that they are not designed to forecast short-term price movements.  Since stock market prices are emotional and therefore often irrationally driven in the short run, no chart, system or philosophy can do that.  The accurate forecast of a stock's short-term movement is purely a function of luck, and nothing else.

Primary Question #2:  How to think about Stock Prices?

Introduction:  In addition to answering Primary Question #1: "How to value a company?", the first section of this tutorial was dedicated to familiarizing you with the design and logic of our charts.  In this section we will assume you already know and understand the mechanics of the charts and therefore focus more on successfully using and interpreting them.  Of course, as before, our main purpose will be answering Primary Question #2: "How to think about stock prices?"

In our experience the most successful investors share a common trait.  They all know "How to think about stock prices."  Wise investors are able to effectively deal with stock price volatility because they possess a clear perspective of what volatility is, why it happens and what it means long-term vs. short-term.

The immortal Ben Graham, father of modern security analysis, and mentor to the likes of Warren Buffet once said: "The Stock Market is always and never rational."  These powerful words hold the key to understanding stock prices and their inherent volatility.  We believe Ben meant the market is rational over the longer run and mostly irrational in the shorter run. 

This makes a great deal of sense when you stop and think about it.  With investing time is the great equalizer.  The longer the time frame, the more rational and the shorter the time frame the less rational.  This can be clearly illustrated by reviewing a company's operating results.

In the short run, investors can merely forecast what future operating results will be.  It's a game of expectations and how these expectations are managed and prompted.  If investors are in a good mood, expectations may be higher than if they are feeling pessimistic.  Emotional basis and levels will have a material impact on immediate (short-term) behavior.  For example, greed can incite speculative fever and fear can incite panic.  When gripped with emotion investors can and will do extreme things.  Intense crowd behavior in any area of life is a volatile and completely unpredictable phenomenon.  The worse thing an individual can do is succumb to it.  It is a most difficult task to maintain composure when everyone around you is hysterical.  A sound knowledge base is the only effective weapon of shield.

As time passes, expectations of future results can be measured against reality allowing reason to rise up against emotion.  Actual results can be better or worse than originally expected and ultimately are the true barometer for value.  The investors who expected too much and paid too much soon discover their error; the same is true for those who sold to low.  Remember there must always be a buyer and a seller for a transaction to happen.  Most importantly, one of them is wrong.

The concept of time is also a major differentiation between an investor and a speculator.  The investor is most concerned with the management, fundamentals and markets of the companies they want to own.  The investor knows that once his money is down, it's the future performance of the business that's important.  They understand that a business takes time to grow and that its future growth is what will ultimately enrich them or not.  Therefore, they are more interested in the company's quarterly report than the company's minute by minute or day-by-day stock quotes.  Speculators are merely trying to guess which direction the price will go next.

top of page