How to predict the future

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Anyone who has been watching the various UK stock market indices over the past few months might have noticed a changing trend. Last year, and earlier this year, large companies were in fashion among investors, with smaller firms firmly out of favour. The index of large companies, the FT-SE 100, was performing much better than the smaller company indices.

Since then, that trend has shown clear signs of reversing. The FT-SE 100 has risen very slightly, less than 1 per cent, since the beginning of April this year, but the FT-SE All Small (a relatively new index combining a number of smaller company indices) has grown by 18 per cent over the same period.

It is hard to say why such reversals happen. Some have suggested that the growth in popularity of index-tracker funds has helped push up the share prices of larger companies. Index trackers simply aim to copy a particular index, and the chosen index is often the FT-SE 100 or the FT-SE 350 (and trackers are a very Foolish way to start investing). But there has always been a cyclical shift between large and small firms.

There are any number of reasons for this. Many investors would never think of touching a smaller company, and some would consider it foolhardy (with a small "f") to take on the extra risk of backing firms whose fortunes depend on a relatively small band of suppliers and customers. Investing in smaller firms does usually make for more volatile returns (that is, the rises and falls in share prices are often a bigger than for large companies). Each of us has to decide for ourselves on the approach we are happiest with.

There are also armies of investors out there who specialise in finding small firms with good growth potential, and it is these that we will examine further. So, are there any Foolish strategies for finding small companies with growth potential? Yes, of course there are.

What we are really after is a steady, sustainable growth in earnings. To measure earnings we look at the earnings per share (eps) figure, which is the company's total net profit divided by the number of shares in existence.

There are two good indicators of earnings growth in a company. First, a good track record of increasing eps over the previous four or five years is a good sign, and second, we want to see analysts' forecasts of continued good growth over the next couple of years too. We should always be sceptical of the accuracy of forecasts, and very conservative when using them. To that end we like to see lots of analysts making forecasts, and are very wary of companies with just one or two forecasts available.

Evidence of growth is not enough for Fools. What if thousands of other investors have also decided a particular company is a great investment, and have already pushed the price up by buying lots of shares? In that case, despite expectations of future growth, there might not be much room for the share price to grow further, as those expectations are already built into today's price. We would do well to avoid such companies.

So we need a way of comparing today's share price with the expected future growth in eps, and a measure often used by "growth investors" is the PEG ratio (we have a Foolish version of this, called the Fool ratio). The PEG compares the company's forecast price to earnings ratio (p/e) with its forecast growth rate. If that sounds confusing, bear with us as it is simpler than you might think.

The p/e is obtained by dividing the firm's share price by its eps, and it gives a measure of how many years' earnings, at the current rate, will be needed to cover the share price completely. The eps growth rate is the percentage growth in eps as forecast by analysts. So divide next year's forecast p/e by the forecast growth rate, and you get the PEG ratio. Most investors think a PEG of around 1.0 represents fair value for a small growing company, and many look for around 0.7 or less before considering buying.

And the Fool ratio? That is a version we think is more conservative. It is obtained by dividing the current end-of-year, or trailing p/e (rather than next year's forecast, or prospective p/e), by the growth forecast. For a company with growing earnings, the Fool ratio will come out higher than the PEG, and so we usually look for a figure of less than 1.0.

No Foolish investor should ever buy a share based on a single statistical measure, but if you can find companies with low PEG or Fool ratios, you have a start. If those companies also have low debt, strong cash flow (particularly when compared with their earnings) and share prices that have been rising over the past year, you might be on to something that deserves closer attention.

n Motley Fool: www.fool.co.uk