Though stock picking is usually more complicated than the basic steps presented here, this sheet con serve as a primer for getting started. This approach is based on the notion that a good company’s stock price is a reflection of its growth and earnings prospects over time. However, to determine whether a company is good from an investment standpoint, you need to ask several questions. Then you need to do a little math to determine whether its stock is selling at a reasonable price.
Is It a Strong Company?
1. Does the cash produced by the company’s sales more than cover its cost of operations? The company’s annual report will include a cashflow page, from which you can compare cash generated from operations to cash spent. It the amount the company generates is less than the amount it spends, it’s likely to have to borrow or issue more stock, which could prove detrimental to current shareholders. Yes. No.
2. Has the company established a record of steady revenue and earnings growth?
3. Is there growing demand for the products and/or services the company produces?
4. Does the company produce or provide a service that is difficult to duplicate? In other words, does it have a patented technology or a particular expertise that ensures it a leading position in its industry for the foreseeable future? Yes. No.
5. Is the company’s return on assets (ROA) 8% or higher or 1% or higher if it is a financial services company? (Companies normally publish return on assets in annual financial statements. However, if it is not spelled out, you can calculate it by dividing the company’s total assets by total (not per-share) net-earnings) Or if the company’s ROA is lower, is it showing strong and steady improvement? Yes. No.
If you answered “yes” to all those questions, you’re probably looking at a good company. Now all you have to determine is whether the company’s stock is selling at a reasonable price.
Is the Stock Reasonably Prices?
Current market price:
Annual earnings per share:
Price-to-earnings ratio (divide price by earnings per share):
Anticipated growth rate:
* You can find these figures in the Value Line Investment Survey. This book, which has an annual subscription rate of $570, is available in most large public libraries.
Compare today’s P/E ratio to what it has been in the past. If it&s; higher than normal, look at how today’s growth rate in net earnings compares with the company’s historical earnings growth rate. If the growth rate is the same or lower than it’s been in th past but the P/E ratio is higher, you have to ask yourself whether the stock is overvalued.
If the earnings growth rate is higher than normal, the P/E may also be higher. Many industry experts generally consider a stock a “buy” when its P/E ratio is lower than their anticipated growth rate. In other words, if a company’s earnings are growing at a 25%-per-year pace, the company may be able to support a price equivalent to 25 times current earnings per share.
But realize there’s a limit to how fast a company can grow--at lease over the long haul. A small company may be able to double its year-to-year earnings for a while, but the chance of maintaining that heady rate falls as the company gets bigger. If you’re paying 50 times earnings, you should ask yourself just how long the company can keep up the pace.