Nancy,
Here is Ralph Seger's reply:
"To improve quality of a stock grossly over valued"
Please keep in mind that the price of a stock tends to be moved by two primary things. These are a P/E ratio change and a change in E/S. For an up side potential these are a P/E ratio expansion and E/S growth. Of these two factors, P/E expansion is the most powerful.
The SSG uses a multiple of the average high P/E ratio and expected EPS five years in the future to estimate potential high price in five years. Let's assume we adjust future P/E ratios using our judgment to the following:
High 34
Low 16
Average 25
We value stocks on the basis of investor's expectations of future EPS. I use analyst's expectations of EPS about 12 months in the future. If you look at "analyst's estimates" for a stock where you are asking for the current price on Yahoo Finance you will find the estimate for this year and next year. "This year" means the current fiscal year. "Next year" means the following fiscal year. Not all companies have a fiscal year which corresponds to a calendar year. Therefore you must make an adjustment between estimates for "this year" and "next year" by using the fraction of a year for "this year" plus the fraction remaining for "next year".
Let's us look at an example. Supposing we are valuing a stock in August and the fiscal year ends in February. This means there are six months from August to the end of the fiscal year in February. Therefore we should multiply the estimate for "this year" by 6/12 and add to it the estimate for 6/12 of "next years" estimate. The result will be analysts estimate of EPS 12 months from August of this year to August of next year. (I realize this is some what complicated, but achieving good results in the stock market takes some work. As Milton Friedman said "There is no such thing as a free lunch).
Let's assume the current price of your stock is 64 and the estimate of future EPS, as described above, is $1.60. Then at a price of 64 the P/E ratio is 64/1.60 = 40. Since we have estimated, using our judgment. that a reasonable value for a future P/E ratio is a high of 34 our stock has already built into its price a P/E ratio that discounts future P/E ratio expansion. We should not expect any rational investor to raise the price much beyond the current price of 64. We conclude the probability of a P/E expansion is quite low. Therefore, it is rational to sell the stock and look for a good quality growth stock selling at a P/E ratio which provides room for a P/E ratio expansion. This would be a stock whose forward P/E ratio is not much more than 25 if is the same as our example. Of course, you should figure out what is a reasonable value for a P/E ratio for any stock being considered. My concept of "relative value" is to calculate the current P/E ratio based on analyst's estimated EPS 12 months in the future and then compare that P/E ratio to what is a reasonable expectation for a future average P/E ratio. In estimating what is a reasonable value for a future average P/E ratio I use the concept of PEG. That is the P/E ratio as a percentage of a reasonable estimate of the future growth rate of EPS.
I realize that a small question was asked and I gave an answer that is like turning a fire hose on one who asks for drink of water. Please note in the above I have frequently used the terms "estimate" and "judgment". As I said in my article " The Theory of the SSG".,successful investing and the use of the SSG is all about judgment. There are no automatic SSGs where you feed in the numbers and out pops the answer.