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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 Frontier Communications (NYSE: FTR ) 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 Frontier.
What We Want to See
Pass or Fail?
|Growth||5-Year Annual Revenue Growth > 15%||7.7%||fail|
|1-Year Revenue Growth > 12%||38.0%||pass|
|Margins||Gross Margin > 35%||83.9%||pass|
|Net Margin > 15%||3.8%||fail|
|Balance Sheet||Debt to Equity < 50%||155.2%||fail|
|Current Ratio > 1.3||0.86||fail|
|Opportunities||Return on Equity > 15%||3.9%||fail|
|Valuation||Normalized P/E < 20||19.80||pass|
|Dividends||Current Yield > 2%||7.9%||pass|
|5-Year Dividend Growth > 10%||(5.6%)||fail|
|Total Score||4 out of 10|
Source: Capital IQ, a division of Standard and Poor's. Total score = number of passes.
Frontier manages just four points on our 10-point scale. Despite having an impressive dividend yield, the rural telecom provider lacks some of the traits you'd like to see in a perfect stock.
Rural telecoms have one major thing going for them: They spit out huge gobs of cash flow, which they have then turned around and paid out to shareholders. That's the major attraction for investors in Frontier, CenturyLink (NYSE: CTL ) , and Windstream (Nasdaq: WIN ) , each of which has extremely high dividend yields that people want in today's low-rate environment.
The challenges come from the nature of the business. These companies lack the growth prospects you'll find elsewhere in the telecom industry. Frontier's recent growth (its revenues tripled last quarter!) has come from acquiring assets from Verizon (NYSE: VZ ) , and despite those new holdings, analysts expect earnings to drop substantially over the next five years. That has already led to a 25% reduction in Frontier's dividend earlier this year, and further drops could come in the future.
The big question is whether consolidation brings economies of scale that improve the prospects for the industry. If so, company cash flows should improve dramatically and prove dour analyst estimates wrong. If not, then Frontier may never get much closer to becoming the perfect stock.
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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