Interrogating the stock market: asking the right questions to select a high-performing stock

In past blogs I have outlined how to determine your risk profile and advice on constructing an economic outlook and the allocation of your assets in your portfolio. This article focuses on the “exciting” part- finding the perfect stock(s). I know you dream of them- that stock that is the equivalent of purchasing shares of Google when it first IPO’d for $85 (it’s at $461 today, 3/25/07). I am by no means an experienced expert on stock selection, but to get you started here are some of the ratios analyzed by the pros, and why they analyze them. This is known as fundamental analysis. This should help you in your approach to selecting stocks for your portfolio, should you have the time. If you don’t have the time, buy an index fund. Selecting a stock for the long-term takes time, analysis, and research. I’m not advising you to take up the practice of day trading or getting into options, because even if you are a finance major reading this, you want to experience those markets via second-hand experience/surveillance or on the job training before you jump in too soon and get slaughtered by the wolves. Everyone wants to make money, right? I’m sure the investment banker at Bear Stearns will have no problem taking you for all you’ve got for a nice yacht to add to his collection.

Where can you get the information for these ratios or the ratios themselves? Try the companies’ website, finance.yahoo.com, or the SEC website (which has the 10-K of all the companies publicly available)

Current Ratio: Current assets/current liabilities
This tells you if the company has enough cash to pay off all their short-term deb. Anything below 1 indicates negative working capital, while anything over 2 means that the company is not investing excess cash.

Debt/Equity Ratio: Total Liabilities/Equity
Indicates what proportion of equity and debt the company is using to finance its assets.
If the ratio is high (financed more with debt) then the company is in a risky position - especially if interest rates are rising.

P/E Ratio: Market Value per Share/Earnings per Share
Used to determine if the company is over or undervalued by the market.
Compare the P/E ratios of other companies in the same industry or against the company's own historical P/E ratios to determine whether or not it is really undervalued or if it is just not experiencing growth. Usually a high P/E ratio means that investors are expecting higher growth in the future. This ratio can be used to estimate earnings to get the forward looking P/E ratio.

Return on Equity (ROE): Net Income/Shareholders Equity
This ratio shows what return a company is generating on the owners' investment. For high growth companies you should expect a higher ROE.

Earnings Per Share: (Net Income - Dividends on Preferred Stock)/Average Outstanding Shares
Determines how much profit was generated on a per share basis. You should compare the EPS of a company to its previous EPS in past quarters to determine if the company is growing.

Cash Flow to Assets: Cash from Operations/Total Assets
This ratio indicates the cash a company can generate in relation to its size-it’s important to compare this ratio of a company from year to year, as a declining ratio could indicate cash flow problems for the company in the future.

Gross Margin: (Revenue - Cost of Goods Sold)/Revenue
This shows how much money on the dollar the company makes from its sales. Higher gross margins are usually better, indicating the pricing strategy of the company. Lower margins indicate the importance of even a penny cost-savings on the bottom line, and how little changes in demand or supply could affect their sustainability.

Tip: Only a novice buys shares in odd lots (i.e. telling your broker you want $2,000 worth of stock A so you end up with 94.3 shares). The pros buy in even lots (100 shares) so figure out approximately how many shares you can afford and round.