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 Home Depot (NYSE: HD ) 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 Home Depot.
What We Want to See
Pass or Fail?
|Growth||5-Year Annual Revenue Growth > 15%||(4.2%)||Fail|
|1-Year Revenue Growth > 12%||1.6%||Fail|
|Margins||Gross Margin > 35%||34.3%||Fail|
|Net Margin > 15%||5.0%||Fail|
|Balance Sheet||Debt to Equity < 50%||59.1%||Fail|
|Current Ratio > 1.3||1.41||Pass|
|Opportunities||Return on Equity > 15%||18.2%||Pass|
|Valuation||Normalized P/E < 20||16.92||Pass|
|Dividends||Current Yield > 2%||2.9%||Pass|
|5-Year Dividend Growth > 10%||14.2%||Pass|
|Total Score||5 out of 10|
Source: Capital IQ, a division of Standard and Poor's. Total score = number of passes.
Home Depot finishes in the middle of the aisle with a score of 5. The home improvement retailer has obviously gotten hurt in the housing bust, but it's been able to maintain an attractive dividend while growing its payout over time.
The housing market hasn't been kind in recent years to homeowners or the companies that rely on them as customers. Lowe's (NYSE: LOW ) saw big declines in same-store sales in 2008 and 2009 with only a small bounce-back last year.
Although the housing bust is the obvious culprit, problems in selling homes can actually help home-related retailers. Selling difficulty has spurred ever-larger numbers of homeowners to spend money remodeling rather than upgrading to a new home. With maintenance and repair accounting for about 40% of Home Depot's sales, that's an important market for the company, for competitors like Lumber Liquidators (NYSE: LL ) , and for suppliers such as fixture fabricator Masco (NYSE: MAS ) and paint maker Sherwin-Williams (NYSE: SHW ) .
Meanwhile, Home Depot has responded to tough conditions by addressing what it can control: costs. In its most recent quarter, cutting operating expenses and improving margins resulted in better earnings despite same-store sales falling 0.6%. That helps support the company's dividend as well, which yields significantly more than Lowe's.
At some point, people will start buying and selling homes again, and Home Depot should see a cyclical bump to add to its internal strategies. It may not be a perfect stock now, but buying in anticipation of that inevitable turnaround could be a smart move.
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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Finding the perfect stock is only one piece of a successful investment strategy. Get the big picture by taking a look at our "13 Steps to Investing Foolishly."