Personal Financial Planning: An "How-To" Guide (part 49)

Selecting a Stock

by

Charles Lamson

You want an investment that provides an attractive rate of return---one that meets or exceeds your required return. So, how do you go about selecting such a stock? The answer is by doing a little digging and crunching a few numbers. Here is what you will want to do. To begin with, find a company you like and then take a look at how it has performed over the past 3 to 5 years. Find out what kind of growth rate (in sales) it has experienced, if it has a strong ROE and has been able to maintain or improve its profit margin, how much it has been paying out to stockholders in the form of dividends, and so forth. This kind of information is readily available in publications like Value Line and S&P Stock Reports, or online, at a number of sites. The idea is to find stocks that are financially strong, have done well in the past, and continue to be market leaders or hold prominent positions in a given industry or market segment. Looking at the past is only the beginning, however; what is really important to stock valuation is the FUTURE! That is, the value of a share of stock at any point in time is a function of future returns, not past performance.

So let's turn our attention to the expected future performance of a stock. The idea is to assess the outlook for the stock, thereby, gaining some insight about the benefits to be derived from investing in it. Of particular concern are future dividends and share price behavior. As a rules, it does not make much sense to go out more than 2 or 3 years because the accuracy of most forecasts begins to deteriorate rapidly after that point. Thus, using a 3-year investment horizon, you would want to forecast annual dividends per share for each of the next three years, plus the future price of the stock at the end of the 3-year holding period (obviously, if the price of the stock is projected to go up over time, you will take some capital gains). You can try to generate these forecasts yourself or you can look to a publication like Value Line to obtain projections (Value Line projects dividends and share prices 3 to 5 years into the future). Once you have projected dividends and share price, you can use the approximate yield equation, or a hand-held calculator, to determine the expected return from the investment.

To see how that can be done, consider the common shares of Medtronic, Inc., the world's largest manufacturer of implantable biomedical devices. According to Value Line, the company has very strong financials; its sales have been growing at around 15 or 16 percent per year for the first five years, it has a net profit margin of more than 20 percent, and an ROE of around 20 percent (2005). Thus, historically, the company has performed very well and is definitely a market leader in its field. In June of 2003, the stock was trading at around $49 a share and was paying annual dividends at the rate of about 30 cents a share. Value Line was projecting dividends to go up about 58 cents a share within the next 3 to 5 years, they were also estimating the price of the stock could rise to as high as $80 a share within 3 years.   

Using these Value Line projections and given current dividends (in 2003) of 30 cents a share, we could expect dividends of, say, 36 cents a share next year (2004), 47 cents a share the year after (2005), and 58 cents a share in 2006---assuming, of course, that dividends do in fact grow as estimated by Value Line. Now, because the approximate yield equation uses "average annual current income" as one of the inputs, let's use the midpoint of our projected dividends (47 cents a share) as a proxy for average annual dividends. In addition, given this stock is currently trading at $49 a share, has a projected future price of $80 a share, and we have a 3-year investment horizon, we find our expected return as follows:

Thus, if Medtronic stock performs as expected, it should provide us with a return of around 17 or 18 percent. In today's market, that would be a very attractive return, and one that very likely will exceed our required rate of return (which probably should be around 12 to 15 percent). If that is the case, then this stock very definitely SHOULD be considered a viable investment candidate. According to our standards, the stock is currently undervalued and thus, should be given serious consideration as a possible addition to our portfolio.

*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK*

end