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No. of Recommendations: 34
Hi KP,

Here is the outline that I made up during the When To Sell Seminar. I hope it makes sense without the lessons to accompany it. Just ask if you are unable to understand a part or two. I am hoping that Erick will be able to elaborate on this after a couple of weeks.



Automatic Sell Rules
1. An SEC investigation. See news areas of Motley Fool
Portfolio, Quotes & Data, SEC Website.
2. The CEO suddenly resigns. Same as above.
3. Enormous insider selling of stock. Yahoo Finance:
4. Short Interest surpassing 20%. Same as above.
5. Stock option grants above 3% of total shares (5% for company
under 500M in Sales).
Same as above, find company "Home Page" and
get SEC 10K filings. Find Income Statement; find Average number of
Shares - Diluted; record. Find table of number of shares granted.
#Shares/ # shares granted = % option grants .
6. Company suddenly changes focus. Emphasis change gross
revenue to net margin expansion OR business model.
7. Company focuses on stock price. See conference calls, Wall
Street manipulations, etc.; executives paid based on stock price.

Warning Signs:
1. Slowing Sales growth. See #5 above. Use Income Statement to
get year-over-year sales for past 4 quarters and three fiscal years.
2. Divergent sales and profit growth. Same as above. Use
Income Statement to get year-over-year Net Income Growth. Also see
Quotes and Data, MTF Financials.
3. Plummeting cash Flows. Same as #5 above. Get Statement of
Cash Flows; record operating cash flow past three fiscal years.
4. Watch those Bonds. Yahoo Bond Center:
5. It just doesn't get any better! Fools Quotes and Date;
Snapshot; find Market Cap; see article by Bill Mann on high Market Cap

Gut Checks and Safety Valves
1. Stop Loss: Purchase price multiplied by 0.8
2. 200 DMA: If below look at fundamentals again.

When A Company Becomes Overvalued
Valuation Tool #1 Compare…
                    S&P 500           Your Stock
Dividend Yield

Valuation Tool #2
1. Choose reasonable earnings or FCF multiple (P/FCF), or use today's
multiple of (P/FCF) of S & P 500.
2. Choose rate of return (8-10% most likely for S & P 500).
          8% = 47%  OR  10% = 61%

Q: How fast would company have to grow its FCF over 5 years to
support a stock price growth of 47% (61%, etc.)?

A. Current Market Cap (2002) x 1.47 = Future Market Cap (2007)
Note: 1.61 may also be used.
B. Future Market Cap
_______________ = FCF of Future
Multiple (see #1 above)

C. (FCF Future /FCF Current) yx (1/5) -1 = Annual Growth Rate of FCF

Questions to Answer

a. more or less in comparison to S&P500
b. growth expectations (room for growth
c. rate of growth: slow, fast, tremendous
d. do products and service justify price
e. reverse engineering results

Report Card Part 1 - Business Prospects

A = The company has shown strong, better-than-expected growth in
revenues,profits, and/or cash flows. The company has maintained or
increased its competitive advantage period, and no discernible threat to
its dominant position has arisen since the last evaluation. The company
has minimal levels of debt; its inventories and receivables are stable
or decreasing; and, its executive compensation and full-reporting
policies are cogent, fair, and transparent.

B = Growth of revenue and earnings has been solid, but no more so
than expected. Also the company has remained above its competition in
terms of market share, and gross and net profit margins. The company's
debt, inventory, or receivables line items are not ideal, but there
doesn't seem to be a big threat. The company's stock options program is
generous and clearly discussed, and its financials are easy to read.

C = The company has shown weak or below-expected growth in
revenues, profits, and/or cash flows. There may be some imbalance
between these three numbers (dropping margins, accounting profits
outstripping cash flows), but nothing that sets off an outright alarm.
The company has competition in its market, and this competition seems to
be showing strength. The company's Foolish Flow Ratio may have expanded, indicating it has increased the level of receivables and/or
inventories since the last review. The company is somewhat dependent
upon stock options for compensation and/or has recently repriced or
cancelled and reissued options. Its reporting documents could use some
improvement, but don't seem to obfuscate the actual position of the

F = Company has shown a significant worsening of the quality of
its earnings, as evidenced by lower gross and net margins and poorer
cash flows. The company shows little differentiation of its performance
in these areas vis-a-vis its competition, suggesting that its
competitive advantage is either crumbling or wasn't as strong as we
originally suspected. There's evidence of poor working-capital
management in the forms of high levels of debt, a rapidly disintegrating
flow ratio, a significant increase in inventories and/or receivables,
and possibly a major disconnect with allowance for doubtful accounts.
Research and development expenditures might be decreasing. The company
insists upon maintaining high levels of management-incentive programs
through options, and actually uses the words "to keep management
interests aligned with shareholders." Corporate communications focus on
different measures than they had in the past and don't clearly
communicate the true position of the business.

Report Card Part 2 - Valuation

1. Superior competitive advantage
Most businesses face stiff competition, which holds profits down
to an average level. Certain exceptional businesses, however,
are able to earn higher-than-average profits over a long period
of time because of their competitive advantage. This may come
from a brand name, patents, specialized expertise, or a
monopoly. eBay (Nasdaq: EBAY) is a good example, with its
near-monopoly position in online auctions, or Tiffany (NYSE:
TIF), with its unbreakable branding power.

2. Defensive earnings
Most businesses are subject to the business cycle, where
earnings rise and fall, sometimes falling dramatically at the
trough of a cycle. But defensive companies provide such basic
staples for life that their earnings are relatively unaffected by a
recession. Food/beverage and grocery companies are classic
examples of businesses that ride through a recession with hardly
a dent in earnings. For example, one of Bill's favorite companies
is Church & Dwight (NYSE: CHD), maker of Arm & Hammer
baking soda and other consumer staples. Even when times are
tough, are you really going to skimp on a box of baking soda to
get that nasty fish smell out of your refrigerator? (Please say
no!) One final example: eBay, which has proven itself fairly
recession-resistant because its off-price wares become all the
more prized when budgets are tight.

3. Above average growth
Above average growth is the most commonly known reason for
a premium valuation. When a company grows profits at a high
rate, it's worth a premium. Defining "above average" is tricky,
but there tends to be a premium for companies that grow profits
faster than 10% annually. We could give many examples, but
we'll once again point to eBay, which over the past year has
grown its free cash flow by an incredible 184%.

A = Significant undervaluation. This company maintains
better-than-average economics but sits at a multiples to earnings or
free cash flow equal to or less than other companies. It's possible that
short-term considerations have conspired to knock the company's price
down to levels indicating we should consider it for a purchase.

B = Fairly valued. These companies don't leap off the page as
screaming buys, as some of the worst-case scenarios would impact its
performance in a way that the share price may not have fully discounted.
Still, with some luck and skill, the company could reward its
shareowners with market-beating returns.

C = Fully valued. The company has some growth and premium baked
into its price. This company should be looked at in conjunction with
other factors, including a P/E or P/FCF ratio over the last five years
or more to ensure that its economic potential isn't overestimated. If
an investor sees better opportunities for his money, this stock might
be a good one to sell as a source for those funds.

F = Grossly overvalued. Sometimes a cheery disposition can be
quite expensive. Companies with potential threats on the horizon and
those with nothing but rave reviews from the investment community are
dangerous. A company showing degradation in its competitive advantage
will become overvalued at a much lower multiple than one still
dominating its market. However, any company, regardless of competitive
strength or market potential, can reach the point where anything but
the most rosy scenario possible has been priced in. In such cases, a
company can be labeled overvalued, regardless of the perceived promise
of its market.

Business Prospects
Valuation A B C F
A BUY Buy/Hold Hold Sell
B Buy/Hold Hold ? Sell
C Hold ? Sell Sell
F Sell Sell Sell Sell

? = judgement calls - do you have a better place for your funds?

Read along the top line for the business prospects and down the
side for the valuation. Where the row and column meet is your

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