An indispensable ingredient in successful stock evaluation and selection is the application of ―judgment. While not nearly so complicated as some would have you believe, this is nonetheless more of an art than a science. It‘s a personal skill that you will develop and fine tune as you gain experience.
However, don‘t be intimidated by your lack of experience if you‘re new at it. In fact, because you‘re apt to be more conservative than the investor who has been doing it for a while, you could very well have better results.
The essence of judgment, in this context, is the application of the wisdom that you gain about industries, the natures and ―personalities of companies within certain industries—or just in and of themselves—and the significance of the factors that contributed to the history that you are studying. Such items as the extent to which acquisitions—rather than increases in sales— contributed to growth, the extent of past and potential competition, the changes in management, and so on, all contribute to your judgment. Nor are these at all mysterious. They are all common sense issues that you will simply be more mindful of as you progress.
The approach described below is a very basic approach to help those of you who may be still learning fundamental investing to make the crucial judgment decisions. Each of these suggestions is directed toward the most conservative action to take on the basis of the numbers and the pictures that you see, alone. You may very well change these steps as you grow in experience and gain confidence.
The Three Levels of Judgment
There are three distinct levels of ―judgment:
1. Discounting irrelevant data or ―Cleaning up data to be sure that only applicable data is used in assessing historical trends or performance.
2. Estimating future trends or performance based upon the historical assessment.
3. Estimating future price performance based upon those future trends.
1. Discounting Irrelevant Data
With respect to the relevancy of data, we know that history cannot be denied. What has happened has happened, and the only decision that you can make about an historical event is whether or not it is applicable in your study to influence your vision of the future.
Eliminating ―outliers is your way of discarding irrelevant data to make historical information more useful and to guide you toward the next step.
2. Estimating Future Trends
Using your conservative historical trends as starting points, you seek to predict what the future trends in the company‘s performance might be. Here again, you will want to be reasonably modest in your view of the future.
Analysts are paid to be accurate. You are rewarded for being right.
The more modest your estimates, the more likely you are to be right!
3. Estimating Future Price Performance
By making careful and conservative estimates of the company’s performance, you can then forecast, within limits, how the stock‘s price will perform—and therefore what kind of return you might expect your investment to give you.
Generally, it pays to accept the conservative alternative in all cases when decisions must be made. Lower estimates in projected growth rates will result in less optimistic price predictions. Since you are focused upon investing rather than speculating—and since there are many stocks available that can meet your requirements—it would seem foolish indeed to ―fudge the figures just to justify the purchase of a particular stock.