Finding the Best Small Companies to Invest In

Written by

Jae Jun

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2012 Forbes Best Small Companies to Invest In

Finding great ideas is difficult. If you are lucky, you’ll come across several a year, but there is a way to find better ideas.

One method that I always look forward to finding the best small companies to invest in is the annual 100 Best Small Companies list published by Forbes.

The methodology used by Forbes in finalizing these small companies is quite simple.

  • strong sales and earnings growth
  • publicly traded for at least a year
  • generate annual revenue between $5 million and $1 billion
  • stock price no lower than $5 a share
  • excluded financial institutions, REITs, utilities and limited partnerships

In additional to these, here is how the rankings are calculated.

The rankings are based on earnings growth, sales growth and return on equity in the past 12 months and over five years; we dropped thinly traded names and those with fuzzy accounting or major legal troubles. We also factored in stock performance versus each company’s peer group during the last year as of Oct. 5.

I’ve been going through this best small companies list since I found it in 2009, and have found and learned about many interesting names as well as profiting from a few that I had conviction in. I was particularly impressed with the companies from the 2011 list.

Shares of last year’s members rose 30% on average, which matched the Russell 2000 small-company index. Last year’s top performers were Zoll Medical, SolarWinds, Cirrus Logic and HealthStream. All of them saw their stocks jump at least 135% over the past 12-months.

Let’s take a look at the top 3. Company financials and other metrics were taken from the OSV Stock Valuation Models.

#1 Solarwinds (SWI)

SolarWinds, Inc. (SolarWinds) designs, develops, markets, sells and supports enterprise information technology (IT), infrastructure management software to IT professionals in organizations of all sizes. The Company’s product offerings range from individual software tools to more comprehensive software products that solve problems encountered by IT professionals.

  • Listed again in the top 10
  • Sales growth of 38%
  • ES growth of 36%
  • ROE of 54%
  • Solid balance sheet with no debt
  • Negative cash conversion cycle
  • Piotroski score of 4
  • Valuation ratios look expensive. PE of 50, EV/EBITDA and P/FCF of 30
  • ROE is slowly drifting down
  • CROIC is extremely high, but coming down also
  • Number show high accruals and reaching warning levels in 2011. Sloan ratio was 27% in 2011.

Solarwinds was also in the top 10 in last years best small companies list and for any holder out there, it has been a great company to invest in. It is difficult to value a company with such fast growth as there is high chance of overvaluing the company as well undervaluing the company based on the current numbers.

Instead, the best way would be to see how much growth is expected from the current stock price to see how reasonable the current valuation is.

Using a reverse DCF with starting FCF input of $128m and 12% discount rate, the required growth currently expected from the price is 25%.

Performing a reverse Graham formula valuation using the analyst estimate EPS of $1.33, a growth rate of 24% is required to meet the current stock price.

Using Katsenelson’s Absolute PE method, and reverse engineering the PE, the expected growth rate comes out to 25%.

The difficult question then becomes whether Solarwinds will be able to achieve this growth going forward and for how long?

I’m afraid, I’ll have to let you answer that one.

#2 Grand Canyon Education (LOPE)

Grand Canyon Education, Inc. is a provider of post secondary education services offering graduate and undergraduate degree programs in education, healthcare, business and liberal arts. The company offers online, as well as ground programs in Phoenix, Arizona.

  • Sales growth of 47%
  • EPS growth of 236%
  • ROE of 27%
  • Increasing net margins annually
  • Low debt
  • Exponential increase in capital expenditures
  • Current ratio is below 1 (but not at the risk of bankruptcy)
  • Watch for accrual build ups

The capital expenditure values blue the free cash flow number too much to be of much help. What I mean by this is that in 2006, capex was recorded as $2.4m and in 2011, it was recorded as $80.5m. This growth in capex is unheard of. According to TTM figures, the capex currently sits at $20m which is far too low considering that the average capex over the past three years has been $60m.

Instead the better number would be to use owner earnings in the DCF stock valuation.

Performing the same reverse valuation exercise as before, a growth rate of 12.5% is required for the stock price to be valid based on

  • discount rate of 12%
  • starting owner earnings value of $66m

A reverse Graham valuation shows a required growth of only 6% if the analyst earnings of $1.50 is used in the calculation.

The Katsenelson Absolute PE shows that the current growth rate based on its PE is 13%, but the fair value is $27 which bakes in an expected 19% growth in the price.

#3 American Public Education (APEI)

American Public Education, Inc. is a provider of exclusively online postsecondary education with an emphasis on serving the needs of the military and public service communities. The Company operates through two universities: American Military University (AMU), and American Public University (APU).

  • Sales growth of 44%
  • EPS growth of 55%
  • ROE of 35%
  • Increased gross margins each year
  • Zero debt
  • Zero intangibles and goodwill
  • Rising SG&A leading to lower net margins
  • First time the Sloan Ratio has reached the warning level using TTM number
  • Beneish score of 1.1 is a huge warning sign for earnings manipulation

Based on many valuation ratios alone, I am surprised that American Public Education came out to be number three on the list.

APEI should be categorized as a value stock based on the following numbers below.

According to the DCF valuation model, the expected growth is 17% which I find a little too high for this company.

From a different angle, using the Katsenelson Absolute PE model, the current expected growth rate is 10% from the stock price of $32.44 but the fair value comes out to be around $38 which means that the expected growth rate for the fair value is 14%.

Download the Top 50 Best Small Companies to Invest Spreadsheet

I’ve only gone through the top 3 so far, but as you can see, two show promise at the right price, while APEI will require a closer look. Are these the absolute best small companies to invest in? So far, that answer is not clear, but I will continue to make my way through the best small companies and will post my findings. I’m sure there will be many great companies to invest in, but in the meantime, you can download and review the top 50 stocks organized into a nice spreadsheet.

Click the image below to download the spreadsheet.

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