Every investor would love to stumble upon the perfect stock. But will you ever really find a stock that provides everything you could possibly want?
One thing's for sure: You'll never discover truly great investments unless you actively look for them. Let's discuss the ideal qualities of a perfect stock, then decide if Arch Coal (NYSE: ACI ) fits the bill.
The quest for perfection
Stocks that look great based on one factor may prove horrible elsewhere, making due diligence a crucial part of your investing research. The best stocks excel in many different areas, including these important factors:
- 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 mean nothing if a company can't produce profits from them. Strong margins ensure that company can turn revenue into profit.
- Balance sheet. At debt-laden companies, banks and bondholders compete with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
- Money-making opportunities. Return on equity helps measure how well a company is finding opportunities to turn its resources into profitable business endeavors.
- Valuation. You can't afford to pay too much for even the best companies. By using normalized figures, you can see how a stock's simple earnings multiple fits into a longer-term context.
- Dividends. For tangible proof of profits, a check to shareholders every three months can't be beat. 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 Arch Coal.
What We Want to See
Pass or Fail?
|Growth||5-Year Annual Revenue Growth > 15%||12.8%||Fail|
|1-Year Revenue Growth > 12%||36.3%||Pass|
|Margins||Gross Margin > 35%||22.2%||Fail|
|Net Margin > 15%||2.0%||Fail|
|Balance Sheet||Debt to Equity < 50%||113.6%||Fail|
|Current Ratio > 1.3||1.55||Pass|
|Opportunities||Return on Equity > 15%||3.0%||Fail|
|Valuation||Normalized P/E < 20||17.66||Pass|
|Dividends||Current Yield > 2%||1.4%||Fail|
|5-Year Dividend Growth > 10%||(15.6%)||Fail|
|Total Score||3 out of 10|
Source: S&P Capital IQ. Total score = number of passes.
Since we looked at Arch Coal last year, the company has kept its three-point score. The big drop in valuation comes from the stock having lost 75% of its value over the past year, and the coal miner recently slashed its dividend as coal demand has fallen prey to lower prices from its main competing energy source.
Coal has been a big driver of electricity generation for decades. But plunging natural gas prices in the face of supply discoveries from shale gas and other unconventional gas plays have made using coal less attractive to utilities. That has forced Patriot Coal (NYSE: PCX ) to close mines to cut costs, and Arch now trades at less than half its book value.
The worst of the damage may be yet to come. Utilities Duke Energy (NYSE: DUK ) , Progress Energy, and Xcel Energy have all adjusted their coal usage or are trying to renegotiate contracts for coal deliveries in response to the situation. Peabody Energy (NYSE: BTU ) expects overall coal demand for power generation could drop 10% this year, representing 100 million tons of coal.
The main driver going forward is likely to be China. On one hand, China's growing economy requires more electrical capacity, pushing demand for power plants of all types. But the country is looking at renewable energy projects like solar to meet that demand. If China and other emerging nations go with solar and wind over coal, then a primary underpinning of the coal industry will disappear.
Arch has historically stood out from peers Patriot, Peabody, and Alpha Natural Resources (NYSE: ANR ) because of its dividend. But with its previous payout ratio climbing above 100%, Arch decided to cut its payout by 73% and will now pay out just $0.03 per share in quarterly dividends. That's bad news for shareholders, and until natural gas prices rise, Arch will continue to face a tough road toward perfection.
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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Editor's note: A previous version of this article used incorrect data that did not reflect Arch Coal's recent dividend cut. The Fool and the author regret the error.