What You Should Look For in a Stock

 

Worldwide Invest Better Day 9/25/2012

To make money picking great stocks, you have to know what you're looking for. But what you need to know can vary from company to company. What's more, there's often a ton of noise and chatter about news, metrics, and stock movements that may or may not be useful to you.

So, in anticipation of Worldwide Invest Better Day, I've put together handy guide based on a class I teach to new investors about what to look for in a stock. Even experienced investors should find this checklist useful.

Here's what you want to look for in four common kinds of stocks:

1. Blue chips
Does this company offer stability and the prospect of attractive returns?

Blue chips are large, prominent, stable companies that investors like to buy for predictable success, so as to balance risk and reward.

The key to this predictability is to identify companies with strong competitive advantages trading at reasonable valuations.

  • High returns on equity, assets, and margins: You want to see a company that scores high on these metrics relative to its industry. Roughly speaking, though, a return on equity above 15% can be a sign of a competitive advantage.
  • Healthy, consistent earnings growth: Ideally, earnings are consistently growing in at least the 5% to 15% range over multiple years.
  • Reasonable valuation: It's not unusual to pay a P/E of as much as 20 times earnings for a faster-growing blue chip with a strong competitive advantage, but make sure the price you pay isn't too high for the quality of company you're buying.

Example: McDonald's (NYSE: MCD  ) is ubiquitous. In fact, it has the sixth strongest brand in the world, according to Interbrand's 2011 rankings. Its brand and scale give it a major competitive advantage that results in whopping returns on equity, assets, and margins, as well as robust growth. A P/E of 17 is quite reasonable for such a strong company.

2. Dividend payers
Is this dividend big, sustainable, and growing?

Investors looking for income in their stock investments should look for stocks whose dividends are big enough, affordable, and growing over time. (Since long-term dividend sustainability depends on a sustainable business, great dividend stocks are oftentimes blue chips.)

  • Healthy dividend yield: I like to see a yield above 2% if I'm buying a stock for its dividend, but keep in mind that once a yield gets into the high single digits, it can be a danger sign (unless the company is a REIT or partnership).
  • Safe payout ratio: When dividends paid approach 80% or 90% of earnings, that's a sign the company may be struggling to afford its payouts or, at the very least, has less margin for raising payouts in the future.
  • Dividend and earnings-per-share growth: It's good to see dividends and earnings-per-share growth in the high single-to-double digits. (Keep in mind that for some industries, like telecommunications, free cash flow may be better gauge of earnings strength than what's reported on the income statement.)
  • Manageable debt: Too much debt can sink a company or limit its ability to increase payouts. Look for moderate debt-to-equity ratios -- ideally, well below 100% -- and comfortable operating income-to-interest payment ratios – hopefully above 5 times. (Up to a point, it's OK for stable, capital-intensive industries such as utilities to have more aggressive debt levels.)

Example: Sysco (NYSE: SYY  ) dominates the U.S. food-distribution business. It has a yield of 3.5%, a moderate payout ratio of 55%, dividend growth in the high single digits, a bit of earnings-per-share growth, and easily manageable debt.

3. Value
Is this stock undervalued?

In essence, all investing is about buying a stock for less than you think it's really worth. But sometimes you think a stock is a particular bargain. The trick is to make sure you're buying a great company at a reasonable price or, alternatively, a reasonably good company at a cheap price. You don't want to buy a poor company at a moderate price.

  • There are lots of ways to estimate how much a company is worth. But at a most basic level, it can be worth keeping in mind that the S&P 500 (INDEX: ^SPY  ) has historically traded for around 16 times earnings. So a struggling-yet-recovering company might be a bargain with a high single-digit P/E, whereas a stronger business could be bargain with a P/E in the high teens.

Example: Hewlett-Packard (NYSE: HPQ  ) has been struggling over the past few years with dumb acquisitions, a fairly incompetent board of directors, and tough competition. But the stock costs only 7.6 times free cash flow. That could turn out to be a bargain if the company's new management is able to turn the ship around.

4. Growth
Is this the next home-run company?

You buy growth companies because you think the business will be substantially bigger in the future. Since they're oftentimes young or investing heavily in future growth, they may not be profitable yet. Perhaps more than any other type of stock, you may have to use your imagination to consider how likely it is a growth company will be able to accomplish what's expected of it.

  • Massive revenue and/or earnings growth: It's impressive for a company to be able to continue growing faster than 20% or 30% per year.
  • Large market potential: Unfortunately, it's harder to maintain high growth rates as companies get larger. Businesses that have lots of room to grow offer products and services for which there will be lots of demand.
  • Growing competitive advantages: Success attracts competition. Unless the company has an advantage like a strong patent, brand, natural monopoly or oligopoly, or high switching costs, competitors will jump in, driving down profitability and preventing all that growth from making shareholders as much money.
  • Underappreciated stock: It's OK for excellent growth stocks to trade at outrageous price-to-earnings or price-to-sales multiples, since you're not buying the stock for today's earnings, but for future earnings. Still, it can be possible to pay too much for a growth stock. To make sure this doesn't happen, it can help to buy businesses that other investors don't yet fully appreciate. One rough way to put a number on it is to estimate a company's sales and margins at some point in the future when you think its profitability will have matured a bit, multiply those earnings by a reasonable P/E, and from there calculate what sort of return that future price would give you.

Example: Even as a massive company, Amazon.com (Nasdaq: AMZN  ) has grown sales at an average annual rate of 35% over the past five years. Technically, it has a P/E above 300, but that's because the company has been investing heavily in growth and expanding its competitive edge through initiatives such as e-readers, Amazon Prime, and perhaps even grocery delivery -- which it already offers in the Seattle area.

The Foolish bottom line
There are lots of different ways to invest successfully. Knowing what to look for will get you a long way to being a better investor. For more great investing lessons, the following button will take you to more on Worldwide Invest Better Day.

Ilan Moscovitz doesn't own shares of any companies mentioned. The Motley Fool owns shares of McDonald's and Amazon.com. Motley Fool newsletter services have recommended buying shares of Sysco, McDonald's, and Amazon.com. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.


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