Decades ago the problem for individual investors was getting enough information without buying costly subscription services. Thanks to the internet, investors now have access to free, real-time data at the click of a button.
The challenge lies in selecting the right information for assessing a specific stock and evaluating it correctly. The process of selecting what stocks to invest in can be simplified by using five basic evaluative criteria.
1. Good current and projected profitability. When choosing stocks, it’s important to consider a company’s financial fundamentals, including earnings, operating margins and cash flow. Together, these factors can paint a reasonable picture of the company’s current financial health and how profitable it’s likely to be in the near and long-term.
On the earnings side, investors should consider how stable those earnings are and how they’re trending. Higher operating margins are typically more favorable than lower operating margins, in terms of measuring how efficiently a company operates. Reviewing the company’s cash-flow figures, specifically cash flow per share, is helpful in gauging profitability. It’s also a way to assess whether a stock is over- or undervalued.
2. Favorable asset utilization. Favorable asset utilization is the ratio of revenue earned for each dollar of assets a company owns. For example, if a company has an asset utilization ratio of 40 percent, it’s earning 40 cents for each dollar of assets it owns. Different ratios are favorable in different industries. Similar to operating margin, the asset utilization ratio is a way to measure efficiency over time.
3. Conservative capital structure. Capital structure refers to how a company funds its business operations, using both debt and equity. A conservative capital structure means that a company characteristically marshals capital in ways that create enough short-term liquidity to cover operating costs, while also reserving enough finance expansion without significantly increasing long-term debt.
4. Earnings momentum. Current or recent earnings, the fixation of many investors, are nothing more than snapshots of where a company is, or was, at a given point in time. To see where companies are likely headed, look for earnings momentum — the slowing or acceleration of earnings growth from one period to the next— as demonstrated by patterns.
Look for these patterns by examining earnings reports over the previous eight quarters, and reading analysts’ projections for future earnings. If a company posted its best earnings of the last five years, two years ago, and has been lackluster since, it may be under increasing competitive pressure.