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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 Rackspace Hosting (NYSE: RAX ) 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 Rackspace Hosting.
What We Want to See
Pass or Fail?
|Growth||5-Year Annual Revenue Growth > 15%||33.5%||Pass|
|1-Year Revenue Growth > 12%||31.8%||Pass|
|Margins||Gross Margin > 35%||70.2%||Pass|
|Net Margin > 15%||7.8%||Fail|
|Balance Sheet||Debt to Equity < 50%||21.5%||Pass|
|Current Ratio > 1.3||1.23||Fail|
|Opportunities||Return on Equity > 15%||15%||Pass|
|Valuation||Normalized P/E < 20||73.84||Fail|
|Dividends||Current Yield > 2%||0%||Fail|
|5-Year Dividend Growth > 10%||0%||Fail|
|Total Score||5 out of 10|
Source: S&P Capital IQ. Total score = number of passes.
Since we looked at Rackspace Hosting last year, the company has gained a point. Better returns on equity are behind the jump, even though the stock hasn't gone anywhere over the past year.
Rackspace is a big player in the hot cloud computing industry. With its coming OpenStack infrastructure, Rackspace tries to make it easy to design software for its open-source platform, marketing that as a competitive advantage over its rivals. Plenty of big customers have agreed that its approach makes sense.
But in its most recent quarter, Rackspace failed to meet earnings estimates. Although the miss was only by a penny, and revenue rose 31%, Rackspace's pricey valuation means that even the tiniest of disappointments can lead to a big move down for its stock. As Amazon.com (Nasdaq: AMZN ) has reduced the prices for its Amazon Web Services, Rackspace faces more competitive pressure.
That pressure will come from several directions. On one hand, Amazon and Microsoft (Nasdaq: MSFT ) are big-name providers that focus on proprietary services to help companies boost their cloud presence. More recently, Google (Nasdaq: GOOG ) announced its entrance into the industry last month with its Compute Engine. Verizon's (NYSE: VZ ) buyout of Terremark also puts it in the competitive framework. But Rackspace hopes that its "fanatical support" will be enough to keep customers coming back to it.
For Rackspace to improve, it needs to deliver on the promises its stock price is already making. Boosting profits will be essential in order for the stock to move closer to perfection in the years ahead.
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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