CI
FEATURE
Rule #1 Stock Screening
By Wayne A. Thorp, CFA
While there have been numerous
successful value investors throughout
the years, Warren Buffet is probably
the most famous. According to Mr.
Buffett, there are only two rules to
investing: Rule #1: Don’t lose money,
and Rule #2: Don’t forget rule #1. In
a new book, “Rule #1” (2006, Crown
Publishers), author Phil Town lays out
an investment strategy that attempts
to follow Mr. Buffett’s rules.
In this article we develop and apply
a stock screen based on Town’s book
“Rule #1.” Also, additional information
on the Rule #1 methodology, including
the backtesting results of our use of
this screen, will appear in the October
2007 issue of the AAII Journal.
The Philosophy
A former green beret turned river
guide, Phil Town was introduced to
Rule #1 investing by a client who was
almost killed during one of his guided
river trips. Following the Rule #1 ap-
proach to investing, Town says he
turned $1,000 into $1 million within
five years.
The key, according to Town, is to
purchase “wonderful companies”
at attractive prices. Armed with the
principles of Rule #1 investing and the
array of quality free financial data and
tools on the Internet, Town believes
individual investors can easily outper-
form the market with just 15 minutes
a week. Table 1 summarizes Town’s
Rule #1 investing approach.
Defining Wonderful Companies
Being able to obey Rule #1 of invest-
ing—not losing money—comes from
“buying a wonderful business at an
attractive price.” Wonderful, according
to Town, is a subjective term. Wonder-
ful businesses are those that follow
Town’s “Four Ms”:
• meaning,
• moat,
• management, and
• margin of safety.
22
Meaning
Town feels that a company can only
hold meaning to investors if they are
willing to make that business their
sole source of financial support for the
next 100 years. To make this judgment
requires a knowledge of what the com-
pany does and who is running it.
However, this does not mean you
need to have detailed knowledge of
the company’s manufacturing and
distribution process. To find compa-
nies that may hold meaning for you,
Town suggests looking at companies
related to your work or hobbies and
interests.
Moat
A moat for a company is similar to
that surrounding a castle, but in this
case is constructed of some minimum
financial requirements. Companies
with wide moats are better positioned
to defend themselves from competi-
tors. Furthermore, Town feels that
wide moats make it easier to predict
a company’s long-term prospects. As
a rule, companies with wide moats
also tend to be well known and among
the top companies in their industry. If
an industry is difficult to enter—has
high barriers to entry—this is another
means of protection for a company.
Most important, however, when
searching for companies with wide
moats, is to find companies that will
be able to maintain that wide moat. A
little later, we will discuss how Town
identifies companies with wide and
sustainable moats.
Management
Since Town takes the viewpoint that
your investment in the wonderful
business will be your sole means of
financial support for the next 100 years,
you need to have confidence in the peo-
ple running the business. Town looks
for CEOs who are owner-oriented and
driven. He cites Microsoft’s Bill Gates
and Berkshire Hathaway’s Warren Buf-
fett as two archetypal owner-oriented
corporate leaders.
All else being equal, Town believes
an easy way to identify an owner-ori-
ented CEO is by their attitude toward
receiving stock options as part of their
compensation. Refusing to accept
stock options, Town feels, signals to
shareholders that the CEO has a long-
term view for running the company.
Another way to learn about a CEO’s
attitude is by reading the annual letter
to shareholders. While not every chief
executive is as candid in the annual
letter as Warren Buffett, Town does
not want a CEO who whitewashes
what happened over the last year. In
Town’s opinion, owner-oriented CEOs
will tell shareholders what went wrong
in the last year, whose fault it was, and
what they hope to do about it in the
current year.
Margin of Safety
The first three Ms help investors to
identify wonderful companies, which
is the first step to Rule #1 investing. The
other side of the coin is to buy these
wonderful companies at attractive
prices. This is where margin of safety
comes into play.
As most investors know, there is
sometimes a difference between how
much something costs and its true val-
ue. Investing with a margin of safety
forces us to quantify a company’s value
and then buy it at a sufficient discount.
In effect, the margin of safety is our
investing life jacket. Even if our initial
analysis was wrong and a company we
buy turns out to be not-so-wonderful,
buying a stock with a margin of safety
protects us from losing money.
Screening: Rule #1 Investing
In establishing the Rule #1 approach,
Town laid out a set of criteria that
would help investors identify “won-
derful companies”—those with mean-
ing, a wide moat, and solid manage-
ment—at a reasonable price—trading
CI
 Table 1.
Phil Town’s Rule #1 Investing in Brief

Philosophy and style
Invest in “wonderful companies” that have meaning to you, which
you should be willing to rely on as your sole means of financial
support for the next 100 years. Look for companies with financial
strength, stability, and quality management whose share price is at
least half their intrinsic value. Buying below intrinsic value provides
a “margin of safety” that protects investors from incorrect analysis as
well as unfavorable company developments, with subsequently less
risk of a market overreaction on the downside. Town believes that,
by following the Rule #1 approach, you can secure at least a 15%
annual rate of return with a minimum level of risk.
Universe of stocks
No restrictions, but Town suggests investing in companies that you
know about or have meaning to you. In other words, companies
that deal in areas related to your work, interests, hobbies, etc. In
addition, he suggests avoiding “illiquid stocks”—those stocks with an
average daily trading volume of less than 500,000 shares.
Criteria for initial consideration
• Minimum compound average annual growth of 10% in earn-
ings per share, equity (book value per share), sales, and free
cash flow over the last 10 years.
• Minimum average annual return on invested capital of 10%
over the last 10 years.
• Manageable debt—the current level of long-term debt should
not exceed three times the level of free cash flow over the last
four fiscal quarters (trailing 12 months)
• Current share price should not be more than 50% of the
company’s fair value, which Town refers to as the company’s
“sticker price.”
Secondary factors
• Look for corporate managers who are owner-oriented. As a
rule, Town avoids companies with CEOs who accept stock
options as compensation.
• Avoid companies where several insiders are selling large por-
tions of their holdings.
• Use technical analysis and charting tools to help time buy deci-
sions.
Stock monitoring and when to sell
• Town states “diversification spreads you too thin and guaran-
tees a market rate of return,” so he instead focuses on only “a
few” businesses in different sectors or industries. However, the
number of companies you invest in is dictated by the amount
of money you have to invest. Try to keep commissions as a
percentage of your total amount invested below 0.5%.
• Town states that there are only two times to sell: 1) when the
business ceases to be “wonderful,” or 2) when the share price
rises above the “sticker price” (fair value).
• Using technical analysis, Town trades in and out of companies
until it is a true sell.

at less than 50% of their fair value or
“sticker price.” Table 2 presents the
approach for our Rule #1 Investing
screen.
AAII’s Stock Investor Pro fundamen-
tal stock screening and research data-
base program was used to perform the
screening for this article. As of August
17, 2007, the database included 8,906
companies.
Wide, Sustainable Moats:
The “Big Five”
One of the things Town looks for in
a company is a wide moat—something
that will protect it from competition as
well as make its future performance
more predictable. However, in order
for a wide moat to be useful to a
company, it must also be sustainable
in the long run. A company with a
wide, sustainable moat is less likely
to go out of business than a company
without one.
To find companies with sustainable
moats, Town uses five pieces of finan-
cial data, which he calls the Big Five
September/October 2007
numbers. They are:
• return on invested capital
(ROIC),
• equity, or book value per share
(BVPS) growth,
• sales growth,
• earnings per share (EPS) growth,
and
• free cash flow (FCF) growth.
ROIC
In Town’s opinion, return on in-
vested capital (ROIC) is the most
important of the Big Five numbers. It
is the rate of return a business makes
on the money it invests in itself each
year. Town defines ROIC as:
Net Operating Profit After Taxes (NOPAT)
Equity + Debt
NOPAT is simply operating income
less taxes. It is different from net
income in that it does not consider
interest expense.
Town states that a strong ROIC is an
indication that the company’s manage-
ment is on the side of its owners.
Town requires that all of the Big Five
figures should be at least 10% per year
for the last 10 years. However, most
screening programs on the market
today only cover five or seven years
of financial statement data.
The screening package you are using
may or may not include ROIC. If it
does, the figure may not be calculated
in the same manner described here.
However, if your screening program
allows you to create custom fields, you
may be able to recreate it. Our screen
looked for an average ROIC over the
last five years of at least 10%.
Equity Growth
Equity is what the company would
have left if it were to sell off all its as-
sets and pay off all its liabilities using
the account value on the books. Town
also refers to equity as the book value
or liquidation value of a company.
In addition, book value (equity) can
be viewed in the context of “retained
earnings.” Companies create equity by
23
 Table 2.
Translating Style Into Screening: Rule #1 Investing

Exchange-Listed Earnings Growth

Town recommends investing in companies with sufficient liquidity;
something many OTC stocks lack. Therefore, we omitted OTC stocks
from our search. In addition, exchange-listed companies meet the
listing requirements for the various exchanges, which establish mini-
mums for company size, share availability, and financial strength.
Non-ADRs
ADRs, American depositary receipts, are securities typically issued
by a U.S. bank in place of the foreign shares of a company held in
trust by that bank. ADRs facilitate the trading of the shares of foreign
companies in U.S. markets. Town does not explicitly state that he
avoids ADRs, but oftentimes there are special tax and unique report-
ing issues related to foreign companies that may complicate matters.
Therefore, we omitted ADRs from our search.
Return on Invested Capital (ROIC)
The average annual ROIC over the last 10 years should be at least
10%. Most screening programs do not offer data going back 10
years. We looked for average annual ROIC of at least 10% over the
last five years. We created a custom field for ROIC based on Town’s
definition.
Equity Growth
The compound average annual growth rate in equity (or book value
per share) over the last 10 years should be at least 10%. Most
screening programs do not offer data going back 10 years. We
looked for an average annual growth rate in equity of at least 10%
over the last five years. This type of growth rate calculation will not
be found in most screening programs, but you may be able to cal-
culate the field yourself if the program allows for custom fields. We
created a custom field for equity growth requiring positive common
equity for the beginning and ending periods.
Sales Growth
The compound average annual growth rate in sales (revenue) over the
last 10 years should be at least 10%. Most screening programs do not
offer data going back 10 years. We looked for a compound average
annual growth rate in sales of at least 10% over the last five years.
The average annual growth rate in earnings per share over the last
10 years should be at least 10%. Most screening programs do not
offer data going back 10 years. We looked for a compound average
annual growth rate in earnings per share from continuing operations
of at least 10% over the last five years. Earnings from continuing
operations provides the best indication of what the firm will earn go-
ing forward and excludes extraordinary, one-time charges companies
sometimes use to manage earnings.
Free Cash Flow Growth
The compound average annual growth rate in free cash flow over the
last 10 years should be at least 10%. Most screening programs do not
offer data going back 10 years. We looked for a compound average
annual growth rate in free cash flow per share of at least 10% over
the last five years.
Debt
Town wants companies that can pay off their long-term debt with their
current annual free cash flow within three years. This type of ratio will
not be found in most screening programs, but you should be able to
calculate the field yourself if the program you use allows for custom
fields.
Margin of Safety
Town feels that the current price should be no more than 50% of the
current “sticker price.” The sticker price is the “fair value” calculated
by first estimating future earnings by projecting current earnings for-
ward 10 years using the lesser of ROIC, equity growth, EPS growth,
sales growth, free cash flow growth, or the analysts’ forecasted EPS
growth rate (the Rule #1 growth rate); then estimating the future
price-earnings ratio by doubling the lesser of the company’s average
historical P/E or the Rule #1 growth rate; and finally calculating the
forecasted future price by multiplying the future price-earnings ratio
by the future earnings per share. The sticker price is the future price
discounted back 10 years at 15% (Town’s minimum annual rate of
return). This field will not be found with any popular screening pro-
grams. It is also unlikely you will be able to create this field yourself
given its complexities.

issuing stock or by being profitable and
not paying out profits as dividends.
Companies that grow book value
normally do so by being profitable
and retaining earnings. As retained
earnings increase, companies can use
this “surplus” (as Town calls it) to
increase their market share or develop
new products.
While most screening services will
include equity or book value per share,
it is unlikely that they will calculate
the growth of these balance sheet items.
However, you should be able to create
a custom field if your screening service
offers this functionality.
Our screen looked for compound
average annual equity growth of at
24
least 10% over the last five years.
Sales & Earnings Growth
While oftentimes company analysis
only focuses on the bottom line—what
the company earns—Town reminds us
not to forget that the top line—sales or
revenues—powers the bottom line.
For both sales and earnings growth,
Town again requires compound av-
erage annual growth of at least 10%
over the last 10 years. Both earnings
and sales growth should be available
in the majority of screening services.
However, many will only offer growth
data covering the last three or five
years.
Our screen looked for compound
average annual growth rates for both
sales and earnings per share of at least
10% over the last five years.
Free Cash Flow Growth
Cash flow growth helps to determine
whether a company is increasing its
cash position with its profits or has
only paper profits. Free cash flow is
what a company has left over from
cash flow from operations after cover-
ing all of its expenses, including capital
expenditures (buying new equipment,
etc.). Depending on the definition you
use, free cash flow may also be after the
payment of dividends. Town, on the
other hand, says that free cash flow is
what the company has left over to pay
CI
dividends or to grow its business.
Our screen looked for compound av-
erage annual free cash flow growth of
at least 10% over the last five years.
Debt
While he doesn’t make it one of the
Big Five numbers, Town says that it is
important that a company’s debt level
is not too high. Rule #1 investors are
trying to find stable, predictable com-
panies. For companies saddled with
a high debt load, a downturn in the
economy or any other “blips” could
force the company to sell off assets
to cover its debt obligations, which
could have a negative impact on the
company’s future.
Ideally, Town would like companies
to have no debt, but he is more inter-
ested in whether a company can pay
off its debt quickly. As a rule, then, he
feels that a company has a “reason-
able” level of debt if its current annual
free cash flows can pay off its long-term
debt obligations within three years. In
other words:
Long-Term Debt <3
Annual Free Cash Flow
It is doubtful that any screening
service you may use would offer such
a screening variable. However, it is
a fairly straightforward calculation
using popular data points, so you
should be able to create a custom field
(if your screening program allows you
to do so).
Our screening required companies to
have long-term debt for the most recent
fiscal quarter that is no more than three
times its free cash flow for the last four
quarters (trailing 12 months).
Calculating the MOS Price
Once an investor finds a company
that satisfies Town’s 10% requirement
for the Big Five numbers and has
a reasonable level of debt, he must
now make sure it satisfies the last M
of investing—margin of safety: Buy
a dollar of value for no more than 50
cents. This margin of safety, it is hoped,
will protect investors if the company
turns out to be not-so-wonderful.
In order to arrive at Town’s margin
of safety (MOS) price, an investor
must first determine the “true” value
of the company—the “sticker price.”
From there, the MOS price is merely
one-half the sticker price.
Sticker Price
To arrive at the sticker price, Town
uses four pieces of information:
• current earnings per share (EPS),
• estimated EPS growth rate,
• estimated future price-earnings
ratio (P/E), and
• minimum acceptable rate of return
from this investment.
Current EPS
The first piece of information we
need is the company’s earnings per
share (EPS) for the latest 12 months
(last four fiscal quarters), which is
readily available at any number of
financial Web sites. The current value
of a company—as reflected in its stock
price—is based on expectations of the
company’s future earnings power.
When calculating the sticker price, we
want to know what the earnings per
share will be in 10 years. Town bases
this estimate on the current annual EPS
and the estimated EPS growth rate.
Estimated EPS Growth Rate
Frequent investment disclaimers
warn that past performance does
not guarantee future performance.
However, past performance provides
perhaps the best indication of what
may happen going forward. Therefore,
when trying to predict future earnings
growth—what Town terms his Rule #1
growth rate—Town looks at the Big
Five numbers as a guide.
However, he believes that the best
indicator of future earnings growth
is not the historical earnings growth
rate. Instead, he gives priority to the
historical annual growth rate in equity.
Citing Benjamin Graham and Warren
Buffett, Mr. Town explains that com-
panies that are not able to grow their
equity, or “surplus,” will not have the

Table 3.
Rule #1 Passing Companies

ROIC 5-Yr Avg Annual Growth EPS LT Debt- Volume Insider 52-Wk
5-Yr FCF/ Grth to- 10-Day Sell Mkt Rel
Avg Equity Sales EPS Shr Est FCF Avg Trades Cap Strgth
Company (Exchange: Ticker) (%) (%) (%) (%) (%) (%) (X) (000s) (X) ($ Mil) (%) Description
Pinnacle Airlines Corp. (M: PNCL) 32.0 11.7 32.5 40.4 22.7 20.0 0.49 624 22 325.7 140 regional airline hold co.
Odyssey Re Holdings (N: ORH) 10.6 20.5 23.1 121.8 69.1 14.0 0.92 557 4 2,673.4 20 reinsurance underwriter
RenaissanceRe Holdings (N: RNR) 14.1 18.2 33.1 31.2 16.1 12.3 0.65 1,008 29 4,095.9 2 reinsurance & insurance
First Marblehead Corp. (N: FMD) 39.7 114.4 84.0 89.8 58.5 36.1 0.07 1,421 51 3,145.9 –13 education lending servs
NutriSystem Inc. (M: NTRI) 28.8 110.7 88.6 160.1 176.3 23.5 0.00 1,441 16 1,697.3 –16 food for weight mgmt
InterDigital, Inc. (M: IDCC) 27.6 35.5 55.6 68.8 202.9 23.3 0.01 1,687 0 1,212.6 –23 digital wireless tech
Palomar Medical Tech. (M: PMTI) 25.7 97.5 49.9 50.0 35.2 22.4 0.00 600 0 555.6 –26 laser cosmetic prods
Travelzoo Inc. (M: TZOO) 33.7 110.1 62.7 122.1 102.8 20.0 0.00 460 0 262.3 –50 Internet media co.
Median for Rule #1 Stocks 28.2 66.5 52.8 79.3 63.8 21.2 0.04 816 10 1455.0 –14.5
Median for All Exch. Stocks 7.0 9.6 10.4 15.4 7.5 14.5 12.52 308 1 466.7 –4

Exchange Key: M= NASDAQ National or NASDAQ Small Cap Market, N= New York Stock Exchange
Source: AAII’s Stock Investor Pro/Reuters Research, Inc. Data as of August 17, 2007.

September/October 2007 25
 Table 4.
Rule #1 Data Calculations for Travelzoo Inc.

Calculating ROIC for the last five years and the average ROIC over the last five years:
Gross operating income – Income tax × 100
Y1 Y2 Y3 Y4 Y5 ROIC =
Income Statement Equity (common) + Short-term debt + Long-term debt
Gross operating income ($ mil) 29.7 14.9 11.1 3.7 1.4
Income tax ($ mil) 14.2 7.9 5.1 1.7 0.6 ROIC Y1 = [(29.7 – 14.2) ÷ (36.8 + 0 + 0)] × 100 = 42.1%
Balance Sheet ROIC Y2 = [(14.9 – 7.9) ÷ (48.5 + 0 + 0)] × 100 = 14.4%
Short-term debt ($ mil) 0.0 0.0 0.0 0.0 0.0 ROIC Y3 = [(11.1 – 5.1) ÷ (40.3 + 0 + 0)] × 100 = 14.9%
Long-term debt ($ mil) 0.0 0.0 0.0 0.0 0.0 ROIC Y4 = [(3.7 – 1.7) ÷ (3.8 + 0 + 0)] × 100 = 52.6%
Equity (common) ($ mil) 36.8 48.5 40.3 3.8 1.8 ROIC Y5 = [(1.4 – 0.6) ÷ (1.8 + 0 + 0)] × 100 = 44.4%

ROIC 5-yr avg = (ROIC Y1 + ROIC Y2 + ROIC Y3 + ROIC Y4 + ROIC Y5) ÷ 5

ROIC 5-yr avg = (42.1% +14.4% +14.9% +52.6% +44.4%) ÷ 5 = 33.7%

Calculating the five-year compound average growth rates for sales, EPS, equity, and free cash flow:

Y1 Y6
Sales ($ mil) 69.50 6.10
EPS-Continuing ($/shr) 1.08 0.02
Equity (common) ($ mil) 36.80 0.90
Free cash flow ($/shr) 1.03 0.03

Compound avg annual growth rate = {[(Ending value ÷ Beginning value) ^ (1 ÷ # of years)] – 1} × 100

Sales compound avg growth rate = {[(69.5 ÷ 6.1) ^ (1 ÷ 5)] – 1} × 100 = 62.7%
EPS-cont compound avg growth rate = {[(1.08 ÷ 0.02) ^ (1 ÷ 5)] – 1} × 100 = 122.1%
Equity compound avg growth rate = {[(36.8 ÷ 0.90) ^ (1 ÷ 5)] – 1} × 100 = 110.1%
FCF/shr compound avg growth rate = {[(1.03 ÷ 0.03) ^ (1 ÷ 5)] – 1} × 100 = 102.8%

Calculating long-term debt-to-free-cash-flow:

Long-term debt Q1 ($ mil) 0.00

Free cash flow 12m ($/shr) 1.01
Average shares outstanding Q1 (mil) 15.25

Long-term debt-to-free-cash-flow per share = (Long-term debt Q1 ÷ Average shares Q1) ÷ Free cash flow per share 12m
Long-term debt-to-free-cash-flow per share = (0.00 ÷ 15.25) ÷ 1.01 = 0.0

Calculating the sticker price:

1) EPS-continuing 12m ($/shr) 1.03

2) Rule #1 growth rate 20.0% <-- The lower of the historical equity and estimated EPS growth rates
Hist. equity compound avg growth rate 110.1%
Est. EPS growth rate (I/B/E/S) 20.0%

3) Future EPS (in 10 years) ($/shr) 6.38

EPS Y10 = EPS 12m × [1 + (Rule #1 growth rate ÷ 100)] ^10
EPS Y10 = 1.03 × [1 + (20 ÷ 100)] ^10 = 6.38

4) Estimated future P/E (x) 40 <-- The lower of the default P/E and the avg. historical P/E
Default P/E (Rule #1 growth rate × 2) 40
Avg. 5-yr historical P/E 101

5) Future market price $255.20

Future market price = Future EPS × Estimated future P/E
Future market price = 6.38 × 40 = $255.20

6) Sticker Price $63.08

Sticker price = Future market price ÷ [1+ (Minimum required annual return on investment ÷ 100)] ^ 10
Sticker price = $255.20 ÷ [1 + (15 ÷ 100)] ^10 = $63.08

Current stock price (8/17/2007 close) $17.20

Current price as % of sticker price 27.3 <-- Must be 50% or less to provide adequate margin of safety

26 CI
funds to expand their market share or Rule #1 growth rate. Therefore, if we Margin of Safety
to develop new products. believe a company’s earnings will The final piece of the puzzle is the
He looks at all the Big Five numbers, grow by 10% a year for the next 10 margin of safety (MOS) price. The
looking for consistency among the years, according to Town we can also margin of safety protects an investor
growth rates and a level of growth expect its P/E ratio to be around 20 in in the event a wonderful company
that the company can sustain over 10 years. The key assumption here is is, in fact, not quite so wonderful.
time. He also takes into account the that the company will continue the rate Therefore, Town does not want to pay
earnings growth forecasts of analysts. of growth over the next 10 years. more than 50 cents for every dollar of
However, throughout his book, the In his examples, Town used the a company’s value.
decision typically rests between the five-year average P/E and compared To calculate the margin of safety
historical annual equity growth rate this to the default P/E. The lower of price, Town divides the sticker price
and the analysts’ forecasted earnings the default P/E or the historical P/E by two:
growth rate. For the sake of conserva- is used as the Rule #1 P/E.
tism, Town uses the lower of the two MOS Price = Sticker Price
and this is what he calls the Rule #1 Future Market Price 2
growth rate. With the future earnings per share Given the complexities of arriving
With the current EPS and Rule #1 and the future price-earnings ratio, at the MOS price, you may have a
growth rate, investors can estimate Town calculates the future market hard time calculating it even if your
what the company’s earnings will be price using this common investment screening service allows you to create
in 10 years. Remember, earnings will formula: custom fields.
be compounding over the period, Our screen looks for companies with
such that: P/E × EPS = Price a current stock price that is no more
than 50% of the sticker price.
Future EPS (in 10 years) = Minimum Acceptable Rate of Return The securities passing all of the
EPS 12m × [1 + (Rule #1 Growth Town expects a minimum annual filters of our Rule #1 investing screen
Rate ÷ 100)]10 rate of return of at least 15% from as of August 17, 2006, are presented
his investments. The sticker price is in Table 3.
Estimated Future P/E the maximum price we can pay for a An example of the various data
The next step is to estimate the mul- stock and still get this minimum 15% calculations using one of the current
tiple of earnings per share to assign a annual return over the next 10 years. passing companies, Travelzoo Inc.
given company 10 years from now. Therefore, he uses 15% to discount the (TZOO), is provided in Table 4.
Companies that the market thinks future market price back 10 years to
are going to grow rapidly tend to arrive at the sticker price. The formula
have high price-earnings ratios (P/ is as follows: Wayne A. Thorp, CFA, is editor of
Es). Likewise, the market sees little Computerized Investing and AAII’s
Sticker Price = Future Market Price
growth prospects (or higher risk) for financial analyst.
(1.15)10
companies with low
P/Es. When trying to
forecast a company’s
Rule #1 Investing Screening Criteria for Use With AAII’s Stock Investor Pro
future P/E, Town
wants one that is “just Compare to
right”—not too high, Data Category Field Operator Factor (Field, Value, Industry)
Company Information Exchange Not Equal Over the counter
not too low.
ADR/ADS Stock Is False
Town compares a Growth Rates EPS Cont-Growth 5yr >= 10
“default” P/E to the Sales-Growth 5yr >= 10
company’s average Free Cash Flow-Growth 5yr >= 10
Custom Fields* ROIC-Avg 5yr >= 10
historical P/E and,
Equity (Common)-Growth 5yr >= 10
again, uses the lower LT Debt-to-FCF <= 3
of the two as the esti- Price <= 0.5 Sticker Price
mated future P/E. He
*A text file of the Custom Fields for use in Stock Investor Pro is available for download from
calculates the default
ComputerizedInvesting.com at: www.aaii.com/ci/200709/rule1customfields.txt.
P/E by doubling the

September/October 2007 27