Back to the overview. Ann Cuneaz's Preferred Procedure workshop.
You're already doing it. Anyone who does a Stock Selection Guide has already used the "Preferred Procedure" whether they realize it or not. Preferred Procedure is a simplified income statement. The historical portion of the SSG Visual Analysis is nothing more than a graphical representation of the past ten annual income statements. As long as you've already been using it, why not take a minute to understand it? It's easy. It isn't difficult. You probabily already know most of this stuff anyway. The "Preferred Proceedure" is a fancy name for the income statement. Remember the income statement?
The real difference between the two is that the income statement shows the income from a company between two HISTORICAL points in time like January 1, 2004 to December 31, 2004 or January 1, 2005 and March 31, 2005. Both of these are past events. The Preferred Proceedure (aka the Business Model) is your forecast of what the income statement for the company might reasonably be expected to look like five years in the FUTURE. That's all. What you're doing now. If you're like many people doing the SSG, you're estimating growth in sales first and then estimating eps growth rate to be no more than sales growth rate. In fact, many times they are estimated at the same rate. When you use this common beginner's method you are assuming the rest of the components of the future income statement will grow in the exact same proportion as you've estimated sales to grow. If you've estimated sales to grow at 10% and then estimated eps to also grow at 10%, you've implicitly assumed that expenses and pre-tax profit will also grow at 10% (i.e., that the pre-tax profit margin will remain unchanged). You also assumed that the tax rate and shares outstanding will remain unchanged. What if the pre-tax profit margin changes (i.e. the expenses go up or down by more than 10%)? What if the company issues more stock or buys back stock? These sorts of changes will make the growth rate of eps different than that of sales. How you can estimate EPS better. The Preferred Proceedure allows you to see how changing one or several of the components of the income statement will affect the eps growth rate. It might leave it the same, but it also might increase or decrease the eps growth rate. While this may seem difficult, it's often not. You are already estimating sales and most companies don't have preferred dividends so all you really have to look at are expenses, taxes, and shares outstanding. There are many sources of information, but one simple, readily attainable source is our familiar Value Line stock report. Value Line shows a ten year historical set of data for these three. (OK, it shows net profit margins, but we can live with that.) It also shows a 3 to 5 year estimate for each of these three values. By looking at the 10 year historical section you'll get a idea whether the trend is even, up, or down for each of the three and by looking at the forecast numbers for the future you can see how the analysts think things might change. You can see historical data for pre-tax profit margins by looking at section 2A on the back of the SSG to see the trend in the profit margin. You'll still have to use your own judgment, but its a lot easier when you have Value Line guiding you. As you become more confident in your ability you can venture away from Value Line as your only source of information and include other items like annual reports and 10Q's. You can find a Preferred Proceedure Calculator by clicking here. Congratulations! There. You've just finished your short course on the Preferred Proceedure. If most of the components of the income statement are expected to grow along with sales at about the same rate you won't see a lot of difference between the eps value you get by estimating eps equal to sales over the eps estimate you get by using the preferred proceedure. If the company is changing things a bit you'll be able to see the effect on the estimated eps. You'll have better information so you have better judgment, and make better decisions.
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