18. Analysis Scorecards

The value and growth analysis scorecards follow the same steps as the corresponding analysis chapters. Use the scorecards to document your conclusions while you are analyzing a candidate. You’ll find both in this chapter, suitable for photocopying.

A single analysis step could involve multiple scorecard entries. For instance, Scorecard Step 4, Industry Analysis, includes two tests described in Chapter 7: Industry Growth and Industry Concentration.

The scorecards award points for desirable characteristics and subtract them for undesirable characteristics. Each test is worth a single point. But some tests can add or subtract a point, others can only add a point, and still others can only deduct a point. Some tests can disqualify a candidate from further consideration.

Generally, positive totals reflect strong candidates. But use the scorecard as a guide, not the final answer. It can’t cover all the nuances of your research. Common sense should prevail over numeric scores.

After you’ve analyzed a firm, examine where your candidate lost points, and try to find similar companies without those weaknesses. For instance, look for a prospect with clean accounting if your candidate lost points in that area.

Save the scorecards whether or not you decide to buy the stock. You’ll be amazed at how much you’ll learn by reviewing your scorecards months later in light of the company’s subsequent stock price performance.

Value Stock Analysis Scorecard

I’ll use Paychex, the same company I used to illustrate the value analysis process, to describe how to score a value candidate.

Step 1: Analysts’ Ratings and Forecasts

The best value prospects are stocks that stock analysts don’t like much. The Sentiment Index reflects analysts’ buy/sell ratings, and the scorecard rewards low sentiment scores. Paychex’s Sentiment score was −8, which earned it 1 point on the scorecard.

The scorecard penalizes value candidates with high earnings growth forecasts and/or positive earnings growth forecast trends. Paychex’s negative current year’s earning growth forecast avoided a penalty point in that category. So Paychex scored 0 for earnings growth.

Since its current fiscal year earnings forecast trend was flat, Paychex also avoided an earnings growth forecast trend penalty point. Paychex scored 0 for earnings forecast trend.

So, Paychex earned 1 point for negative sentiment and avoided potential earnings forecast penalty points.

Step 2: Valuation

Value candidates’ share prices should reflect low growth expectations. The scorecard rewards candidates with implied average annual earnings growth below 5 percent and penalizes those with implied growth exceeding 10 percent.

Paychex’s 7 percent implied growth scored 0.

Step 3: Target Price

Buying at the right price is critical for successful value investing. The target price formula establishes a maximum buy price. But this is not a pass/fail test. If a stock is trading above its maximum buy, continue with the analysis. But don’t buy the stock until it trades below its maximum buy price.

Paychex was trading above its maximum buy price when I did the target price analysis.

Step 4: Industry Analysis

Although high growth is okay, the best value candidates are in moderate-growth (9 percent to 14 percent) industries. Stagnant or declining industries are bad news. The scorecard penalizes firms in industries growing less than 3 percent annually and rewards firms in moderate-growth industries.

Paychex is in the computer services industry, which is expected to grow sales around 11 percent annually. Thus, Paychex scores 1 point for industry growth.

The scorecard also awards 1 point for candidates in concentrated industries. I evaluated Paychex’s payroll-processing industry, having only a few players, as concentrated. Thus, Paychex also scores 1 point for this category.

Step 5: Business Plan

Transfer the business plan score computed during your analysis, up to a maximum of plus or minus 4 points, to the scorecard. Paychex’s business plan score totaled +4. Thus, Paychex earned 4 points for business plan. If its business plan score were higher than 4, it would still score only 4 points.

Step 6: Management Quality

The right management can make a good company great, so the scorecard rewards companies with key executive and board quality that you graded as very good or excellent. Ineffective management’s results will show up in other performance measures, and the scorecard doesn’t deduct for low grades. I rated Paychex’s management as acceptable, so it didn’t earn a point for this test.

Most firms do have clean accounting and show reasonable earnings growth stability, so the scorecard penalizes those that don’t pass these tests, but it doesn’t reward those that do.

I rated Paychex’s accounting as clean, and its earnings growth stability as excellent, so it didn’t lose any points.

Step 7: Financial Health

Failing the appropriate financial health test disqualifies a candidate. I used the Detailed Fiscal Fitness Exam to analyze Paychex, and it passed. No points are associated with this test.

Step 8: Profitability

The best value candidates were highly profitable before they stumbled and can be expected to return to previous profitability levels. The scorecard rewards firms with expected return on assets above 14 percent and penalizes those below 6 percent.

Paychex’s recent ROAs in were in the 10 percent range, above the 8 percent historical norm. I assumed that Paychex would continue to generate ROAs in the 8 to 10 percent range, so Paychex scored no points in this category.

Step 9: Red Flags

Since value candidates, by definition, are underperforming, the existence of balance sheet or revenue growth red flags does not affect the score.

But the depreciation versus capital expenditures yellow flag test does apply. Deduct 1 point if a stock fails this test. Paychex passed, so it scored 0 points for red flags.

Step 10: Ownership

Very high insider ownership spells risk, and this test penalizes firms in that category. Paychex’s 11 percent insider ownership was far below the 55 percent limit, so Paychex wasn’t penalized.

Step 11: Price Chart

A strong price chart indicates that your candidate’s recovery prospects have already been recognized and it’s probably too late to buy. This step penalizes firms with share prices 10 percent or more above their 200-day moving average.

Paychex was trading close to its 200-day MA when I did the analysis, so it wasn’t penalized.

Summary

Paychex scored 7 points. Use these scores to compare candidates you are evaluating.

Growth Stock Analysis Scorecard

I’ll use restaurant operator Buffalo Wild Wings to describe how to fill out the growth stock scorecard.

Step 1: Analysts’ Ratings and Forecasts

The best growth candidates have relatively moderate sentiment scores and strong earnings growth prospects.

The scorecard rewards firms with sentiment scores in the 0 to +4 range and penalizes stocks with scores below −3 (too weak) and above 8 (too strong).

The scorecard also penalizes companies with forecast annual earnings growth below 15 percent.

Negative earnings forecast trends or a history of negative earnings surprises automatically disqualify growth candidates.

Buffalo’s −3 sentiment score earned it 0 points in that category. Its 26 percent forecast current fiscal year earnings growth was sufficient to avoid a growth penalty point.

Buffalo’s earnings forecasts were trending up, and its surprise history was acceptable. Thus, Buffalo passed the earnings forecast trend and earnings surprise checks.

Step 2: Valuation

In the growth stock world, moderately overvalued stocks tend to outperform undervalued stocks. That said, momentum often pushes growth stocks up to unrealistic valuations.

This test rewards stocks trading at PEGs of 1.1 to 1.4 with 1 point and penalizes stocks 1 point that are trading at PEGs above 2.0.

Buffalo’s 0.9 PEG earned it 0 points.

Step 3: Target Price

Growth stocks often trade at prices not justified by fundamentals. This test penalizes stocks 1 point when they are trading within or above their target sell price range.

Buffalo was trading below its low target sell price. Thus, it was not penalized and scored 0 points for this test.

Step 4: Industry Analysis

Good growth candidates are often found in fast-growing, concentrated industries. This test rewards firms in industries growing faster than 20 percent and penalizes those in industries growing less than 10 percent annually. Firms in concentrated industries earn another point, but since most industries don’t fit that description, firms in fragmented industries aren’t penalized.

I estimated Buffalo’s restaurant industry growth at 11 percent, so it did not earn or lose a point in that category.

Since Buffalo operates in a fragmented industry, it also earned 0 points in that category.

Step 5: Business Plan

Transfer the business plan score computed during your analysis, up to a maximum plus or minus 4 points, to the scorecard.

Buffalo’s business plan score of 4 earned it 4 points in this category.

Step 6: Management Quality

Growth and value investors alike benefit by picking firms with quality management. The scorecard rewards companies with key executive and board quality that you graded as very good or excellent. It does not deduct points for poor management.

I rated Buffalo’s management and board quality as fair, so Buffalo did not earn a point for management quality.

Since clean accounting and reasonable, stable earnings growth are the norm, the scorecard deducts 1 point for companies that fail this test. Firms that pass get 0.

I rated Buffalo’s accounting as clean, and its earnings growth was consistent, so it wasn’t penalized.

Step 7: Financial Health

Failing the appropriate financial health test disqualifies a candidate. Buffalo qualified for the busted cash burners test and passed.

Step 8: Profitability

Strong sales growth and profit margins are hallmarks of promising growth candidates. The sales growth test rewards firms with growth exceeding 25 percent and penalizes those growing slower than 15 percent.

Similarly, the return-on-assets test rewards firms with ROA above 14 percent and penalizes those with ROA below 6 percent.

Deteriorating operating margins warn of future problems. Significant margin declines disqualify candidates. By the same token, persistent cash burners are riskier investments than cash generators and are also disqualified.

Buffalo’s recent 30 percent year-over-year sales growth earned it 1 point in that category.

Buffalo’s operating margin had been trending up, not down. Since Buffalo consistently generated positive cash flow, it passed both the operating margin and cash flow tests and hence was not disqualified.

Buffalo’s consistent 10 percent return on assets fell short of the number needed to earn a point in the profitability category.

Step 9: Red Flags

Red flags warn of a future growth slowdown, which is bad news for growth stocks. Hence, any red flag disqualifies a growth candidate.

Yellow flags pointing to longer-term problems signify added risk but don’t necessarily disqualify a stock. Subtract 1 point for each yellow flag found.

My analysis revealed no red flags for Buffalo, so it was not disqualified.

Similarly, I also found no yellow flags for Buffalo, so it did not lose any points in this category.

Step 10: Ownership

Institutional buyers, such a mutual funds, usually load up on growth stocks. It’s a danger sign if they don’t.

The institutional ownership test disqualifies growth candidates with less than 30 percent institutional ownership.

Very high insider ownership may be a tip-off that big shareholders are waiting for an opportunity to unload their holdings. The scorecard penalizes firms 1 point if they have more than 55 percent insider ownership.

When I checked, since institutions owned 77 percent of Buffalo’s shares, it passed the institutional ownership test and wasn’t disqualified.

Since insider ownership totaled 7 percent of shares outstanding, Buffalo did not lose a point in that category.

Step 11: Price Chart

Growth stocks should be moving up in price, not down. Nevertheless, stocks trading far above their 200-day moving averages are riskier than stocks that have just begun their move.

To avoid weak stocks, the scorecard penalizes stocks 1 point if they are trading below their 200-day moving average.

To avoid stocks that may have moved up too fast, the scorecard also penalizes stocks 1 point if they are trading more than 50 percent above their 200-day MA.

When I checked, Buffalo was trading 19 percent above its 200-day moving average, so it passed both checks and was not penalized.

Summary

Buffalo’s score totaled 5 points, but the score by itself has little meaning. Instead, these scores are meant to help you compare various candidates you are evaluating.