Everyone would love to find the perfect stock. But will you ever really find a stock that gives you everything you could possibly want?
One thing's for sure: If you don't look, you'll never find truly great investments. So let's first take a look at what you'd want to see from a perfect stock, and then decide whether BP Prudhoe Bay Royalty Trust
The quest for perfection
When you're looking for great stocks, you have to do your due diligence. It's not enough to rely on a single measure, because a stock that looks great based on one factor may turn out to be horrible in other ways. The best stocks, however, excel in many different areas, which all come together to make up a very attractive picture.
Some of the most basic yet important things to look for in a stock are:
- Growth. Expanding businesses show healthy revenue growth. While past growth is no guarantee that revenue will keep rising, it's certainly a better sign than a stagnant top line.
- Margins. Higher sales don't mean anything if a company can't turn them into profits. Strong margins ensure a company is able to turn revenue into profit.
- Balance sheet. Debt-laden companies have banks and bondholders competing with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
- Money-making opportunities. Companies need to be able to turn their resources into profitable business opportunities. Return on equity helps measure how well a company is finding those opportunities.
- Valuation. You can't afford to pay too much for even the best companies. Earnings multiples are simple, but using normalized figures gives you a sense of how valuation fits into a longer-term context.
- Dividends. Investors are demanding tangible proof of profits, and there's nothing more tangible than getting a check every three months. Companies with solid dividends and strong commitments to increasing payouts treat shareholders well.
With those factors in mind, let's take a closer look at BP Prudhoe Bay.
| Factor | What We Want to See | Actual | Pass or Fail? |
|---|---|---|---|
| Growth | 5-Year Annual Revenue Growth > 15% | 6.1% | fail |
| 1-Year Revenue Growth > 12% | 14.1% | pass | |
| Margins | Gross Margin > 35% | 100.0% | pass |
| Net Margin > 15% | 116.8% | pass | |
| Balance Sheet | Debt to Equity < 50% | 0.0% | pass |
| Current Ratio > 1.3 | 5.16 | pass | |
| Opportunities | Return on Equity > 15% | 9,044.5% | pass |
| Valuation | Normalized P/E < 20 | 22.18 | fail |
| Dividends | Current Yield > 2% | 7.2% | pass |
| 5-Year Dividend Growth > 10% | 5.8% | fail | |
| Total Score | 7 out of 10 |
Source: Capital IQ, a division of Standard and Poor's. Total score = number of passes.
BP Prudhoe Bay scores 7 points, which is quite strong. But as a royalty trust, some of the categories of financial measures don't apply as much to BP Prudhoe Bay as to other stocks.
The key to understanding royalty trusts is that they don't behave like most companies. Unlike BP and other oil production companies, which can move their operations around the world to adjust to changing industry conditions, royalty trusts entitle shareholders to profits from the production of specific oil properties. As its name suggests, BP Prudhoe Bay is tied to the North Slope of Alaska, whereas the similar San Juan Basin Royalty Trust
Investors like royalty trusts because they pay high dividend rates, often with some tax advantages stemming from cost depletion. But royalty income represents a share of proceeds for a depleting asset. In other words, at some point, the wells will run dry, and you can expect your shares to lose value steadily as the remaining reserves go down.
Royalty trusts often perform in line with energy prices, so buying BP Prudhoe Bay is a bet on continuing strength in energy. But don't let the strange-looking financial statements and resulting margin and return on equity figures fool you. BP Prudhoe Bay is a nice way to generate income, but it has its downsides as well, and it's neither an endless fountain of wealth nor a perfect stock.
Keep searching
No stock is a sure thing, but some stocks are a lot closer to perfect than others. By looking for the perfect stock, you'll go a long way toward improving your investing prowess and learning how to separate out the best investments from the rest.
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