Picking a Great Stock - Lesson I

Summary of the Rules:

• Invest in Small Cap Stocks Only
• Company must have had a "surprise" of 20% or more in last quarter
• Seeing Lots of Volume? Beware of institutional traders
• Stock must have an EV/FCV/G ration below 1.0
• PEG should be less then 1.0
  

Let's review them one at a time...

Rule: Company must have positive cash flow

The more the better, nuff said.

Information to do the calculation can be found on "statement of cash flows"

The calculation: Cash flow from operations - capital expenditures

From Motley Fool - Free Cash flow defined

Rule: Invest in Small Cap Stocks Only

Small caps give investors the edge, because institutions tend to ignore them and analysts don't cover them. By the time anyone realizes they're there, they've already grown much larger, and appreciated in price.

Companies with market values between $100 million and $2.5 billion to qualify as a small cap.

"The greatest gains from stock investing are to be found not among the Googles of the world, the well-known, much-loved and overanalyzed large caps. They're found in the tiny corners and crevices of the market, where analysts have yet to tread."

The Motley Fool

Rule: Company must have had a "surprise" of 20% or more in last quarter

Seek companies that had an earnings surprise of 20% or more last quarter, but also have the prospect of growing earnings at least 20% annually for the next five years, according to analysts.

The Motley Fool

Rule: Seeing Lots of Volume? Beware of institutional traders

Many investors say volume is where the large institutional traders leave their footprint on the market.

From Yahoo Investing

Rule: Stock must have an EV/FCV/G ration below 10.0

In other words, I want my small caps to sell at bargain-basement prices. An EV/FCF ratio of 10 or less gets my attention real quick. Anything pricier than that, I need to take a good hard look at the company's growth rate and EV/FCF/G ratio.

Calculation looks like the following;

Free Cash Flow = Cash flow from operations - capital expenditures
Market cap = current share price * total shares outstanding
Debt = long-term debt + short-term debt
Enterprise value = market capitalization - cash and equivalents + debt

From The Motley Fool

• Free Cash Flow
• Enterprise Value

After some consideration, I decided to remove this rule. I believe that the guess part leads to areas where I can make errors in judgment. I do reserve the right to come back and examine this. (Plus I'm not sure I understand all of this one)

Rule: PEG should be less than one.

A ratio used to determine a stock's value while taking into account earnings growth. The calculation is as follows:

Calculated as a stock's P/E ratio divided by its projected year-over-year earnings growth rate. In other words, the ratio measures how cheap the stock is while taking into account its earnings growth. If the company's PEG ratio is less than one, it is considered to be undervalued.

From Investpedia - Definition

Rule: Are you investing in a Value Stock or a Growth Stock?

Value stocks are trading for less than their apparent worth and have potential to get back to and surpass there apparent worth.

Growth stocks are trading higher than their apparent worth but have potential to outgrow there current worth.
From Investpedia

Summary of the Rules:

• Invest in Small Cap Stocks Only
• Company must have had a "surprise" of 20% or more in last quarter
• Seeing Lots of Volume? Beware of institutional traders
• Stock must have an EV/FCV/G ration below 1.0
• PEG should be less then 1.0
  

References

• The Motley Fool - The Science of Stock Picking
  
• The Motley Fool - 7 Steps to Finding Gems
• Investpedia - Stock Picking Strategies (still reading)