For the most RECENT quarterly and annual reports, you should use the MOODY's directories. These directories contain weekly news and quarterly earnings reports about your companies. Look for these quarterly reports right after the relevant quarter ends. For example, if the quarter ends on December 31, then look for a report on earnings around January and February.

Great! Now you have ALMOST all the information needed for your analysis. Half of your PRESEARCH is over and you didn't spend a dime, except for the opportunity cost of time. Although financial statements may seem intimidating at first glance, have no fear. You don't have to be an accountant to decipher them. Besides, accountants never really check the numbers anyway. The numbers are whatever the boss wants them to be. Be aware of this very important point, never take financial statements at face value unless you believe that all accountants are honest and never, ever fudge the numbers. Do your research and be careful, especially with drug companies that have huge earnings volatility. Now that we have scared you a bit, it is time to run the last stretch of the PRESEARCH rat race. Where can we get the advantage with the BEST information possible? Call the company and ask for it! You might as well make use of the phone numbers or addresses you found in the directories.

You can either call the company or write to them, your choice. Ask for the latest press releases, news reports, newsletter recommendations, and of course, the latest 10-K and 10-Q (Wall Street code for annual (K) and quarterly (Q) report). They are always glad to hear from you and will provide any information needed. Usually the Investor Relations department handles all inquiries, however, smaller firms may hire outside public relations firms solely for this purpose. Anyway, just make sure the company puts you on their mailing list so you don't miss any future news. If you are writing, address the letter to the Investor Relations department and ask for everything listed above. Make sure they are sending you the LATEST information.

Now that you have ALL the information you need and then some, you may begin the math section of the exam. Your first step in every stock selection should be eliminating company that does not satisfy the basic valuation standards that you establish. You should spend your valuable time only on those that are worthy of further research. Therefore, when evaluating an issue, always look for reasons to STOP investigating. To help you, we have established the three P's:

1.) First P: P/E Ratio

Here is where the second "P" comes in- the all important price/earnings ratio (P/E ratio). The P/E ratio can be computed easily because it requires only two variables: the price of the stock and the latest annual earnings per share (EPS).

(EQ.1)

PRICE/ EARNINGS RATIO (P/E) =

Most recent stock price

earnings per share (EPS) over the last 12 months (4 quarters)

excluding any extraordinary gains or losses

(EQ.2)

EARNINGS PER SHARE (EPS) =

Net income (annual or quarterly)

weighted average # of shares outstanding

IMPORTANT NOTE** When calculating the P/E ratio of your company, use the EPS figure that EXCLUDES any ONE-TIME gains (or losses). That is, calculate your EPS using only income from continuing operations (income derived directly from revenues/sales). Any extraordinary gains NOT attributable to continuing operations should be discounted. Discounted extraordinary gains can be any ONE-TIME boost to earnings, ranging from discontinued operation gains to income tax credits. And they usually fall under the following headings: Extraordinary Income, Income Tax Credit, Discontinued Operations, or Gain from Sale of Assets. Similarly, any ONE-TIME losses such as a write-off of assets should also be discounted from EPS. Look for these losses under the following: Loss from Discontinued Operations or Extraordinary Loss. Except for gains/losses from discontinued operations, these extraordinary items are usually presented below the line called "Net Income" (from the income statement) and should be carefully analyzed as to its effect on net income, and consequently EPS.

Why do we want to discount ONE-TIME boosts to earnings? Well, because that is just what they are, ONE-TIME. As an investor, you are more interested in the long term horizon of the company and your analysis should not be based on any short term fluctuations that may distort true earnings. Extraordinary items can make earnings either exceptionally high or low, and therefore misrepresent the future. Furthermore, as a good analyst, you should base your analysis on a company's basic business or its "bottom-line" and not on any distracting ONE-TIME extraordinary gains or losses.

What do you do with your company's P/E ratio? Well, just looking at your company's P/E ratio alone means absolutely nothing! Everything is relative, that is, your company's P/E ratio MUST be compared to something else in order to make sense. Just because you find a stock with a low P/E does not mean it is a great investment. BUT, if you find a stock with a low P/E ratio COMPARED to the company's own growth rate as well as compared to the P/E ratios and average growth rates of other competitors, then you have already beat half the people on Wall Street. Remember that the price of a stock should reflect the growth rate of the company and should be priced accordingly. If a company has a higher growth rate than the P/E ratio, the stock may have been overlooked and undervalued. Remember these principles using PEG (Price/Earnings and Growth) analysis.

Here is a summary of PEG criteria:

P/E ratio of your company should be LESS than

1.) average Growth rate of your company (3 to 5 year avg.)

2.) P/E ratios of other competitors

3.) average Growth rates of other competitors

4.) P/E ratio of the market such as S&P 500

In addition to the PEG summary, look for companies in good, high growth oriented industries with relatively low P/E's. These are the stocks with the greatest potential because they have not been chewed to the bone by the Wall Street hounds. Comparing your company's P/E ratio to other competitors is nice, too. But you MUST be sure that your company's growth rate is GREATER, or at minimum, equal to its P/E ratio. This leads us into the final P, Past performance.

Although past performance cannot predict future earnings growth, it is still the best place to start and a good measure of potential growth. Your superstocks should have high growth rates that are accelerating year after year and should have the potential for continued growth in the future. Using the company's income statement, we can calculate relevant growth rates. The income statement is simply a company report that tells you what came in (sales) and what went out (expenses) during a certain time period. We are primarily interested in the growth rate of both revenues (net sales) AND earnings (earnings per share or net income can be used). Both are important and can be calculated easily by anyone without a hangover:

EQ.3

Growth rate of one period to another =

CURRENT figure - PREVIOUS figure (last year, qtr...)

Previous figure (last year or quarter's earnings or sales)

The previous equation (EQ.3) is a general formula for calculating the growth rate of any figure from one period to the next. For example, if ABC Co. earned $.90 per share last year and $1.10 this year, the growth rate of ABC's earnings from 1993-1994 is ($1.10-$.90)/$.90 = 22.2%.

In order to calculate the AVERAGE annual growth rate for the past couple of periods, you should first calculate the growth rates for each period using EQ.3. For example, calculate the growth rate from 1991 to 1992, then 1992 to 1993, and so on. Then, use the individual growth rate figures to determine the average growth rate:

EQ.4

Average growth rate =

[(growth rate1) + (growth rate2) +...+ (growth rateN)]

N periods or years

This is just a simple average. Add up the growth rates for each year and divide by the number of years to get the average growth rate over N years.

The growth equation (EQ.4) will give you the average growth rate for the number of periods you are calculating. When analyzing your company, the average growth rate for both revenues AND earnings per share (EPS) should be calculated using a minimum of at least the last two years or equivalently, the last 8 quarters. The average growth rates of BOTH revenues AND EPS should be increasing and accelerating at a comparable rate. If a company's growth rates are greater than its P/E ratio and the industry average P/E ratio, then you may have found yourself a winner. In addition, the smaller the P/E ratio of your company to the average P/E ratio of the company's respective industry and its competitors, the better (see previous page).

Another screening method is to compare your revenue (or net sales) growth rate to the cost of sales growth rate. It is a bad thing when the costs of making or selling your product starts to increase at a faster rate than you can sell them. Therefore, you definitely want your company's sales to be increasing at a faster rate than their cost of sales. Now there are thousands of comparisons that you could make, but these are the most important. Just remember them as the SEXCE (pronounced "SEXY") growth criteria: S-ales, EX-penses or C-osts, and E-arnings.

SEXCE SUMMARY: **growth rates of net income, earnings, EPS should be similar**

AVERAGE Revenue (Sales) Growth Rate AND

AVERAGE Earnings (Net Income or EPS can be used) Growth Rate

of your company should be GREATER than

1.) P/E ratio of your company

2.) AVERAGE cost or expense growth rate of your company

3.) P/E ratio of competitors

4.) AVERAGE growth rates of competitors

If you are really lazy or cannot afford a calculator, sometimes the growth rates don't even have to be calculated, one can easily estimate simply by looking at the figures, this is known on Wall Street as back-of-the envelope calculations.

In general, if you learn anything from this section, remember with all your heart and soul that BOTH revenues and earnings from continuing operations should demonstrate greater growth than the P/E ratio. The PEG analysis motto: no growth, no dough ($).

Well, that's it for the three P's. Sounds too simple, right? Well, it is. This simple strategy along with some balance sheet analysis and other hints is all you really need. If you think sensibly and not spontaneously, you will do well with the three P's. The three P's will protect you and lead you to the best stocks. Granted, it may take a little time and some practice to find stocks that match the criteria, but these companies are out there for you to discover.

Now that we've tackled the income statement, let's look at its partner, the Balance Sheet (BS). The balance sheet is a table of the business' assets, such as cash, securities, inventories, and receivables, as well as "fixed" assets like the plant, buildings, equipment, computers, etc. It explains how the company is financed between amounts of debt and owner's equity. Debt is divided into short-term (bills due, payables, and loans due in the next year) and long-term (mortgages, bonds due over many years, etc.). Furthermore, the balance sheet is calculated periodically and at a specific time (e.g., December 31). We shall use the BS to determine the financial fitness of your company.

The value of your common stock is ultimately derived from the assets it represents and the earnings it promises. If you buy it for less than its real value, you minimize risk and maximize the potential for gain. But in order to buy below real value, you must first have an idea of what constitutes the real value of a stock. And to do that, you need to evaluate promised earnings (SECTION VI) AND ASSETS, which we shall do now.

What is the single most important asset? $$$$$$$. Pure, unadulterated CASH is the best asset to own and the only believable part of a balance sheet. Unlike old, heavy machinery or plant equipment that cannot be sold easily, cash is liquid and takes care of itself. As long as you throw it in the laundry every now and then, money needs no maintenance. Therefore, cash is the best asset your company can have. On the balance sheet, the heading of "Cash and Cash Equivalents", is exactly what it says; there is no deception here. Just like the money you have stashed in the old, burglar-proof shoebox, the more cash, the better.

For example, Too Cheap Corp. has 1 million shares outstanding and has $1 million in pure cash stored in its underground personal bank vault. Also, the nasty word- DEBT- is not listed on Too Cheap's balance sheet, and its other liabilities are negligible. This means that the company has $1 in cash per share of stock ($1M/ 1M shares).

Because brokers were too busy counting their commissions, they overlooked the stock of Too Cheap Corp., which is trading at $1.50 per share. Translation: Too Cheap's stock is too cheap! For every share bought at $1.50, you are getting ownership of $1 per share back in cash from the vault. You have essentially paid only $.50 ($1.50 minus $1) extra for the rest of the company's assets and future earnings prospects. Furthermore, the $1 per share of cash actually provides a floor price for the company's stock. Technically, if Too Cheap's stock price falls below $1.00 and you buy, you will have received more in assets than what you paid. When "cash & cash equivalents" exceed the company's stock price, you effectively get the company for FREE. If the company has any growth potential, you have indeed found yourself quite a bargain. Needless to say, companies like Too Cheap are rare. But the point is: "cash is king AND queen".

Marketable securities and anything else that resembles the liquidity of cash can be counted as cash substitutes. Like cash, the more, the better. Marketable securities are usually highly liquid investments such as short-term bonds, government or municipal bonds, and money market funds.

So far we have covered the more important parts of a company's balance sheet. Now let's weed out the bad seeds that can force companies to swallow the bitter fruits of bankruptcy. Yes, here comes that vitriolic, horrible, derisive, disgusting, and offensive 4 letter word that induces a mind-numbing chill down the spines of every broker or analyst out there, DEBT. Just like you, companies also need some borrowed money to finance operations. What makes debt so dangerous? Well, you have experienced it for yourself in terms of monthly mortgage payments for your mansion, interest payments on your Lamborghini loan, and especially those darn student loans for college that takes the rest of your 9 lives to pay off.

Okay, let's put cash, marketable securities and long- term debt in proper perspective. For a company to be in good financial shape, the total of cash, cash equivalents, and marketable securities should ALWAYS be greater than long-term debt at the very least. We realize there are not many companies that may satisfy this rule, but we want you to be protected. The only SAFE DEBT IS NO DEBT. Remember this rule, it will give you a good night's sleep and protect you in times of crises.

4.) Cash vs. Debt

To summarize the rules (*):

1.) Current Assets > Current Liabilities = Minimum Requirement

2.) Cash & Equiv. > Long-Term Debt (LTD) = Attractive

3.) Cash & Equiv. > LTD + Current Debt = Extremely Attractive

4.) Cash & Equiv. > LTD + All Current Liabilities = Gorgeous

(*) Cash & Equivalents include Marketable Securities and other short-term investments that are very liquid.

The first rule simply says that if the company had to pay off all its recent bills tomorrow, it would have enough cash and equivalents, such as inventories quickly convertible into cash to cover the bills. As for the second rule, if the company was forced to pay off its long-term debts tomorrow, it could do so without difficulty. These rigid rules ensure that the president of your company will not be reading Chapter 11 of the bankruptcy book anytime soon. As we move down to the fourth criteria, the picture gets brighter and brighter. To protect yourself, your company SHOULD be able to satisfy the first and second rules at a minimum. Remember, we want the healthiest companies possible for our money.

The four rules summarized above are very rigorous because we want only the BEST companies in the BEST financial shape. This provides protection for you and your money. If you find a company that satisfies rule #4, call up the president of the company and buy dinner because this company has taken all the vitamins needed to stay healthy. You may think that these debt-free companies are impossible to find, but they are out there.

Remember that regardless of how wonderful the BS (balance sheet) may be, a company that is not generating revenue and earnings growth is not worth your time. We don't care if the company is making your favorite toy in the world, don't waste your time! To maximize profit, a company must satisfy ALL criteria. On the other hand, don't discount a company due to a little extra debt either. If the company is not over-priced and has high enough growth rates to justify its debt, give it a second look. Use good judgment and common sense.