Chapter One
Forget About Conventional Analysis
Seeking a professional's opinion makes sense in lots of situations. Say
you're about to agree to buy a house. If you don't happen to be an engineer
who specializes in judging structural soundness and safety, it might be a
good idea to hire someone with that expertise to look the place over. Or
suppose you can afford a painting by a famous artist to hang on a wall in
that house, but you don't know the art market well. You'd be wise to pay a
consultant who can tell you where comparable works sell at auction.
It might seem to follow that if you're trying to pick next year's #1 stock,
you'd want to look for it in research produced by people who analyze stocks
for a living. Equity analysts employed at Wall Street firms or independent
research organizations know the companies they follow inside out, thanks
to specializing by industry and concentrating on a small number of stocks.
Over many years of studying their industries, they've developed valuable
contacts at their companies' suppliers and customers.
As a result, analysts often know what's happening on the ground before it
shows up in earnings reports or newspaper articles. What's more, these
stock evaluators process vast amounts of data. That complements the
judgment they've developed through lengthy experience. Most Wall Street
equity analysts are also extremely bright. And you can learn exactly which
of these brainy and highly motivated analysts are considered the best in
their field, thanks to annual surveys and scorekeeping by various
organizations, most famously by Institutional Investor.
Despite those assurances, do you want to run the top analysts' top picks
through one more battery of tests? No problem. Their recommendations,
which are based on “fundamental” factors such as companies' competitive
strength and earnings prospects, are complemented by “technical” analysis
that's conducted by a separate group of highly intelligent professionals.
Also known as “chartists,” they make predictions about stocks' future
movements based on statistical relationships between price trends from one
period to the next.
No doubt about it, there's a lot of intellectual firepower for you to draw on
as you attempt to identify the year's highest‐return stock before it takes off
for the moon. The question is whether any of it is useful in that quest. I'm
not disputing the value of the skills that enable premier analysts to
command big‐time compensation packages. It's just that the system they're
part of isn't geared toward the objective that's the focus of this book.
From Earnings Forecasts to
Recommendations
A typical Wall Street equity research department includes specialized
analysts covering a wide array of industries—high‐tech, low‐tech,
financials, commodities producers, consumer goods, business‐to‐business,
and more. The competitive dynamics of those industries vary tremendously,
but the analysts boil their work down to a uniform, easy‐to‐understand set
of acronyms.
Each analyst projects the company's earnings for the coming year and
divides that amount by number of shares outstanding to produce an earnings
per share (EPS) estimate. Dividing the company's share price by its
projected EPS produces the price‐earnings (PE) multiple. PE multiples are
also calculated with trailing‐twelve‐months EPS as the denominator.
PE multiples vary according to companies' perceived earnings quality and
expected future EPS growth rate. The analyst assigned to a given company
renders an opinion on what its PE ought to be, based on how it stacks up on
those factors against other companies in its industry. Multiplying the
company's “correct” PE multiple by its projected EPS produces a price
target (PT).
Based on where the stock's current price stands relative to its PT, the analyst
assigns a rating to the stock. The ratings terminology varies by firm, but the
most straightforward set‐up consists of a Buy, Hold, or Sell
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