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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 if Brocade Communications (Nasdaq: BRCD ) fits the bill.
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 Brocade.
|Factor||What We Want to See||Actual||Pass or Fail?|
|Growth||5-Year Annual Revenue Growth > 15%||28.7%||pass|
|1-Year Revenue Growth > 12%||12.9%||pass|
|Margins||Gross Margin > 35%||52.4%||pass|
|Net Margin > 15%||6.2%||fail|
|Balance Sheet||Debt to Equity < 50%||48%||pass|
|Current Ratio > 1.3||1.50||pass|
|Opportunities||Return on Equity > 15%||6.9%||fail|
|Valuation||Normalized P/E < 20||46.34||fail|
|Dividends||Current Yield > 2%||0%||fail|
|5-Year Dividend Growth > 10%||0%||fail|
|Total Score||5 out of 10|
Source: Capital IQ, a division of Standard and Poor's. Total score = number of passes.
A score of 5 makes Brocade look pretty good. But long-term shareholders would certainly disagree, as shares remain 95% below their level 10 years ago.
Brocade has faced a challenging time in recent years. Despite decent revenue growth, Brocade's net income has started to shrink. Margins and returns on equity are down sharply from 2005 and 2006. Fortunately for Brocade, competitors QLogic (Nasdaq: QLGC ) and Emulex (NYSE: ELX ) are arguably in even worse shape on their income statements. But that's hardly a ringing endorsement for Brocade's shares.
What ends up saving the stock could be a takeover. Last year, when the company put itself up for sale, Hewlett-Packard (NYSE: HPQ ) and Oracle (Nasdaq: ORCL ) were seen as potential buyers. More recently, rumors that IBM (NYSE: IBM ) wants to buy the networking company are undoubtedly responsible for some of the stock's run-up over the past two months. Until things sort themselves out in the industry, expect Brocade's shares to give investor a rocky ride.
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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