Model Based Stock Picks

We don’t want to give away the secret of our success but we will share some of the features of the model we use to value stocks. The process begins with the selection of candidates. This is accomplished primarily by performing stock screens, reviewing financials journals, and analyzing companies with recent press coverage. Once a stock is considered a candidate it is reviewed to determine if it has a chance to make our group of about 60 stocks that we follow on a continuing basis and consider the best values on the market. This screening process requires a stock to meet our minimum accepted levels of positive free cash flow, revenue growth, net tangible assets, risk, and future outlook. If a stock meets these levels and we think it could make our actively followed list then a formal analysis is performed to determine what we believe is its intrinsic value. This process requires close scrutiny of a company’s SEC filings (10Q, 10K statements) for the past 20 quarters which makes it a time consuming process. We go into levels of depth in analyzing fundamentals that can’t be duplicated with popular stock screening engines.

  • Long Term Growth Rate – this is necessary to project how much free cash flow the company will produce in the future
  • Free Cash Flow – the current average free cash flow to which the long term growth rate is applied to determine future free cash flows
  • Shares Outstanding Growth Rate – we track how fast a company dilutes its shares. This is overlooked by most analysts but it is important because a shareholder’s ownership percentage decreases as the number of shares outstanding rises. We track the diluted number of shares outstanding rather than shares outstanding in our screening. This is a better gauge of value because it takes into account all of the stock options, warrants, and other securities that could be currently converted into common stock. Dilution lowers shareholder value and should not be ignored.
  • Net Tangible Assets  – this value is added to discounted future cash flows when determining intrinsic value.
  • Discount Rate – this value is based on a company’s weighted average cost of capital (WACC).

In addition to rating stocks based on their discount to intrinsic value we also rate the stocks based on a ratio of PFCFG (Price to Free Cash Flow ratio divided by Growth). You may be familiar with the PEG ratio (PE ratio divided by Growth) which is a quick way to determine if a stock may be undervalued considering its growth. This is similar but with free cash flows substituted for earnings. To determine this ratio we analyze a company’s previous 20 quarters and its projected future 8 quarters of revenue to arrive at a suitable growth rate. The projected revenue guidance provided by a company during quarterly conference calls and press releases is also used in the growth determination. A projection of free cash flow can be made based on the percentage of free cash the company was able to extract from past revenue. We prefer companies with consistent free cash flow generation because it makes this process more reliable. After free cash flow and growth rate are determined it is just a simple math step to determine a fair price assuming you use a standard PFCFG ratio. This price is really a fair value 8 quarters into the future but since stock prices are forward looking measures the stock should be trading at this price in the near future.

We combine the intrinsic value and PFCFG results with other metrics that tend to favor companies with consistent results and hinder those with high risk factors. A final valuation is assigned to a candidate and then it is ranked against our actively followed stocks. If candidates rank among the top 60 or so stocks that we actively follow then we will add it to the group and may drop a lower ranked stock. Changes in the rankings occur daily as prices move, earnings are released, and future expectations are modified. At the end of every month we provide our subscribers with the 10 highest ranked stocks for the following month’s portfolio.