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 Rosetta Stone (NYSE: RST) 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 Rosetta Stone.

Factor What We Want to See Actual Pass or Fail?
Growth 5-Year Annual Revenue Growth > 15% 39.8% Pass
  1-Year Revenue Growth > 12% 2.6% Fail
Margins Gross Margin > 35% 84.9% Pass
  Net Margin > 15% 5.1% Fail
Balance Sheet Debt to Equity < 50% 0% Pass
  Current Ratio > 1.3 2.17 Pass
Opportunities Return on Equity > 15% 7.9% Fail
Valuation Normalized P/E < 20 37.62 Fail
Dividends Current Yield > 2% 0% Fail
  5-Year Dividend Growth > 10% 0% Fail
  Total Score   4 out of 10

Source: Capital IQ, a division of Standard and Poor's. Total score = number of passes.

With just four points, Rosetta Stone's business hasn't translated into huge success. The language learning expert has huge potential but hasn't made good on it lately.

Rosetta Stone has gone through a lot in its short two-year history as a public company. After its IPO shortly after the market bottomed in early 2009, the stock soared as investor interest pushed the shares well above their offering price. As the sole major provider of language software, investors focused on the potential to grow the business into a high-value franchise.

Unfortunately, the company hasn't been able to convince U.S. customers to pony up for its high-priced offerings, which has pushed shares back below their original IPO price. Revenue has fallen as CEO Tom Adams admitted in his most recent conference call that competition from free and low-priced alternatives, such as those from Berlitz, Disney's (NYSE: DIS) Publishing Worldwide, CBS's (NYSE: CBS) Pimsleur, and McGraw Hill (NYSE: MHP), cut into profits.

Where Rosetta Stone hopes to pick up the slack is in international sales. Where U.S. customers currently feel little urgency to learn foreign languages despite the increasingly global economy, international customers have big incentives to learn English, Chinese, and other big-economy languages in order to compete. That's a potential growth opportunity for Rosetta Stone.

Whether Rosetta Stone can convert on that opportunity will determine whether it becomes a perfect stock. With some hard work, the company could easily get itself back on track to fulfill the promise it had when it first went public two years ago.

Keep searching
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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