Over the next few days we will learn about “The Preferred Procedure.” For the uninitiated, the Preferred Procedure is simply a method to make “revenue-based” earnings per share projections 5 years into the future.
I consider this to be a BASIC workshop. Many people regard the Preferred Procedure to be an advanced topic, but I don’t. The only prerequisite is a basic understanding of the SSG. Newbies might want to consider this workshop to be the next step.
The attached file, Day1_slides.pdf, contains several pictures that are referred to in the text.
Before we get into the Preferred Procedure we need to discuss a little background. A basic understanding of the income statement is critical to understanding the Preferred Procedure, so that is where we will start. Then we will take a new look at the visual analysis (graph) of the SSG to help us “see” how a company operates.
The income statement summarizes sales and expenses over a period of time, usually one quarter or one fiscal year. The top line is the total amount of money the company received from sales of products or services to their customers, and is generally called sales or revenue, depending on the nature of the company’s business. The bottom line is called net income (or net earnings or net profit). Net income is the final profit after all the expenses and taxes have been deducted from sales.
The income statement is designed to be read in a step-down manner, like walking down a set of stairs. Each step down, after the revenue figure, is a deduction of one or more expenses.
Simplified Income Statement
Revenue
$
1000
-
If I would have had your income statement explanation from the start I believe the SSG would have made a lot more sense.
Welcome, Ann, and thanks for taking the time from your busy schedule to educate us in the use of the preferred procedure. I'm glad you're spending some time on the inter-relationship of the three lines on the visual analysis. When I open an SSG for a new company, I like to look at pretax profit relative to sales on the front before looking at section 2A. Then 2A becomes nothing more than a confirmation of what I already see on side one.
I am really looking forward to this workshop...always something new to learn.
Nancy Isaacs
Long term investing made simpleBetterInvesting Community
> We’ll also demystify that scary Preferred Procedure calculator screen in Toolkit.
For those who don't have Toolkit, there is an interactive Preferred Procedure calculator at http://biwiki.editme.com/calcIncomeStatement
The BI Wiki calculator does not appear to handle preferred dividends . They may not be common but you shouldn't ignore them when they do exist.
Also preferred dividends are not an expense. They are an allocation of net profits. They are subtracted from net profits as preferred shareholders do have preferential rights ahead of common shareholders. The remaining net profits available for common shareholders is what is used as the starting point for calculating earnings per common share.
(The situation can become extremely messy if you are dealing with convertible preferred.)
Diane Graese
Las Vegas
Understanding the Preferred Procedure Workshop – Day 2
Today we will get into the details of the Preferred Procedure calculation, going through an example step-by-step. We will also take a close look at the Preferred Procedure calculator screen in Toolkit, and try to figure out what all those boxes are for.
The attached file, Day2_slides.pdf, contains several pictures that are referred to in the text.
The Preferred Procedure
The preferred procedure is simply another way to calculate future earnings. It’s also known as the “revenue-based method” of projecting EPS, because the preferred procedure begins with our revenue projection and develops an expected income statement for 5 years in the future. From this expected, or projected, income statement, the future EPS is calculated. The preferred procedure helps us to understand the connection between future sales and future earnings. The preferred procedure is often used by experienced investors as a second opinion, or a reality check, against which their initial EPS growth projection can be compared.
The preferred procedure requires 5 year projections for many of the items we looked at yesterday on the income statement:
1. Revenues
2. Pretax profit margin (pretax profit as a percent of sales)
3. Tax rate
4. Preferred dividends
5. Number of shares outstanding
For each of the above, a five year projection must be made. Judgment must be applied to each, based on historical trends, and what we think the company will do in the future. (more on judgment in days 3 and 4).
The Preferred Procedure Calculation - Step by Step
Let’s first take a look at the calculation needed to use the Preferred Procedure. You will see a lot of similarities between these and the calculations on the income statement. It’s a step by step procedure that ties our projected revenue to our projected earnings per share (EPS) five years in the future
1) Start with the projected revenue
2) Multiply by projected PTP margin
= Pretax profit
3) Less projected taxes
= Net Income
4) Less preferred dividends
= Income available to common shareholders
Ann,
>>In this hypothetical case, let’s say we have studied the company’s historical performance and what management plans to do in the future (i.e. sell higher margin products and cut expenses further). We have concluded that pretax profit margin will grow from 20% to 22%.<<
After a while you become attuned to the need for the two main judgments required, i.e. pretax margin and # shares outstanding.
I happen to be a notetaker and for each of my companies I have a paragraph for margins and a paragraph for # shares.
When I read news releases or articles or read messages posted in the forum or on the i-club-list about one of my companies, my attention is drawn to any comments about potential margins or # shares and I add a note. When I get to the preferred procedure, I access those notes and try to apply the information to my judgment for future shares or margins. So if ACS announces they are selling off a low margined division of their business or when Biomet announces initiation of a share buyback program, I make a note of it, knowing that I will be referring to that note when it comes time to apply the preferred procedure calculations.
Once you start listening for this sort of informations, you find clues all over the place. At least this method helps me. I know you haven't gotten to judgment yet, but I thought I'd mention this since it occurred to me when you talked about management's plans to cut expenses or sell higher margined products.
Your presentation is excellent so far....very easy to follow. I know I'll be referring this workshop to forum members time and again in the future.
Nancy,
>>I happen to be a notetaker and for each of my companies I have a paragraph for margins and a paragraph for # shares.
You are much more organized than I am, and I am looking forward to your "following my stocks" workshop <g>.
You are right that you quickly learn what to pay attention to. When I find a little tidbit, I do a cut and paste to the "Notes" section of Toolkit. That way my extra information is stored right with my SSG. I do make sure that I date, and note the source of the item.
And thanks for the kind words (from you and others). I hope people will find this to be helpful.
Ann
>>When I find a little tidbit, I do a cut and paste to the "Notes" section of Toolkit. That way my extra information is stored right with my SSG. I do make sure that I date, and note the source of the item.<<
That's a good idea, especially for any notes that might be directly applicable to SSG judgments. I do find that any notes need to be edited on a regular basis, as they get out-of-date or just unweildy before long.
> The BI Wiki calculator does not appear to handle preferred dividends. <
I added preferred dividends to that calculator. You might need to refresh your browser cache to get the latest (ctrl+F5 in Internet Explorer).
http://biwiki.editme.com/calcIncomeStatement
> Do you use the [Biwiki] "income statement calculator" as a replacement for the PP calculator found within Toolkit? <
No. That calculator is there because I thought it would be helpful to those reading the BIwiki preferred procedure pages to have access to such a calculator without needing any additional software. I mentioned it here because I thought some readers might be interested too.
Understanding the Preferred Procedure Workshop – Day 3
Now that we have the basics out of the way, we will begin our discussion on guidelines for judgment. Today we will tackle 2 of the key judgments - future sales growth rates and pretax profit margins.
Please see the attached file, Day3_slides.pdf, for pictures that are referred to in the text. Additionally, we will use the attached Home Depot Value Line report for some of the discussion.
Estimating Future Sales
I make an initial estimate of future sales by reviewing the historical sales growth (of course). If the past growth has been steady, future growth can be projected with more confidence. I do pay particular attention to the most recent trends, as this tends to be the most relevant data. But beyond looking at the graph, I like to do a little more research.
Simply stated, price multiplied by quantity equals sales. So sales can be increased by raising prices and/or selling more products. We want to estimate how sales will grow in the future. To do this it is imperative that you know and understand the products or the services provided by the company you are studying. Now I’m not saying that you need to be an expert in the field, but you should be able to give a one or two minute summary on the company’s products and/or services. You really can’t begin to determine what will drive the future sales growth if you don’t have a basic understanding of the company’s products.
So what can drive or limit future sales growth? Consider the following:
· Does everyone that wants the product (or service) have the product (or service)? If no, then there could be growth ahead. But if the answer is YES, then this could be a limitation to growth.
· Is the company branching out to new locations? A regional company that is expanding to be a national company might be expected to be increasing sales in the future. But if the company is already national or international, it may be difficult for the company to continue growing sales as they have in the past. This could be a limit to future growth.
· Might there be new uses for old products? Consider Church & Dwight Co., Inc., makers of ARM & HAMMER® Baking Soda. This company has successfully transformed baking soda from being a (small) ingredient in baked goods, to a cleaning agent and a deodorizer. If you were the manufacturer of baking soda, would you rather have your customer use your product a spoonful at a time, or put whole boxes in the fridge to make it smell good, or better yet, dump entire boxes down the garbage disposal to “freshen”? I think the answer is fairly obvious.
· What products are in the pipeline? New, must-have products are very important to the growth of technology and drug companies, and will often drive future growth. Future block-buster drugs, or lack thereof, can make or break a pharmaceutical company. If is for this reason that research and development is an important type of expense for these companies. Companies that depend on new products must work hard to stay one step ahead of their competition.
Ann wrote:
Note: It was recently brought to my attention that the Annual Rates box is reporting per share growth rates. You need to be aware that this is not the same as sales growth rates, and can be affected by the number of shares going up or down.
>>>>First let me thank you for leading this workshop. So many topics seem complicated, but when broken down into their components are really pretty simple. Hard by the yard, but a cinch by the inch as my uncle used to say.
I believe you see the same thing in either PERT A or its graph.
It has been said the PERT A or its graph show the exact same thing as the SSG with new quarterly data plotted.
By plotting the actual numbers on the front of the SSG you'll get a true picture of the growth occuring for sales and pre tax profit.
I'm glad you confirmed this difference for me.
>>So reviewing the historical profit margins, considering my research of how Home Depot is getting more efficient, increased growth in the higher margin home improvement services area, and the recent pretax profit margin quarterly trends, I am estimating the future pretax profit margin to increase to 9.8%, up from the default value of 9.6%. <<
Actually your estimate turned out to be a bit conservative. I see that 2003 and 2004 came in at 10.6% and 10.8%. Ellis would say you were not accurate but you were right <g>. I find myself more and more projecting pretax margin at the rate of the current year when the SSG displays a consistently increasing trend unless I have reason to believe the trend will reverse. I'd need a really good reason to project further margin improvement though.
Again your presentation continues to be simply put and easy to follow. I bet there is a bunch of lurkers out there absorbing your every word. I just wish some of them would speak up. If one reader has a question, you can bet a whole bunch of others have the same question and will learn from your response.
Norm,
I'm not Ann, but I'll tell you what I do. As I mentioned before I am a notetaker. I don't search for the answers to Ann's various items, but I do have a paragraph in my notes for Revenues. Any time I read an article about the company, or the Morningstar report, or a news release on Yahoo or hear someone on the i-club-list or forum discussion the company, I keep tuned in for clues about revenues. So if I read something about the pipeline, or about a new or discontinued product, or about pricing pressure, etc. I jot a note under my paragraph on revenues. Then, when I am attempting to project sales, I glance at that paragraph for hints. Short of any specific information in that paragraph, I do the same as you, i.e. rely on VL's estimate on the right and the company's history of revenue growth tempered by column T in the PERT-A.
PTP margin = Net profit margin ¸ (1 – tax rate)
