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How To Grade A Potential Stock Investment
One word that should die a quick death in 2021 is ”STONKS”. It is the child of the following stock market misconceptions: -You only lose if you sell for a loss -Stocks always go back up -Buying a blue chip company and holding guarantees a return
If you’ve picked a good company with a solid balance sheet and bought at a nice discount, then sure, you should not sell while the stock is down. This, however, requires more investigation than just picking a Wall Street darling stock. Take a look at a small list of companies that were once Wall Street darlings that wound up in failure: -Enron -Radio Shack -Toys R’ Us -Sears -Blockbuster -Worldcom -Lehman Brothers -Circuit City -Nokia
With the tons of new traders and investors that have started buying stocks in the past year, there’s a growing misconception that overtime individual stocks go up. This is exacerbated by the fact that indexes, do, tend to go up overtime. The movement of the stock market indexes should not be falsely equated to the movements of individual stocks over set periods of time because the indexes are weighted, and re-weighted periodically, to move with the best performing companies that trade within those indexes. The list of the best performing stocks today, will not be the list of the best performing stocks in ten years. Let’s look at a checklist that you can use to make sure that the odds are that your company can remain on the list of best performing companies a decade from now.
You can use these methods to grade a stock that you are thinking about buying. Almost none of the companies you look at will meet all of these criteria, but if the company can get a passing grade than you’ve got a great company. You should still wait for the right price, whether you’re looking at the 200 day moving averages, the Ben Graham formula(s) (we’ll go over these in future articles), the price that you buy the stock at is of great importance because the more of a discount you get the better your returns will be. What’s more important than that, is the financial health of the company which we will help you tackle here. You can find the necessary information listed below on your company’s quarterly and annual reports via their investor relations website. Yahoo finance and MSN.com will have the numbers as well.
Use the following list to grade the company that you are thinking of buying the stock of:
-Does the company have sufficient net income to pay off it’s long term debt within 4 years?
-Does the company spend less than 30% of it’s gross profit on Selling, General, and Administrative costs? -Is the company's gross profit margin at 40% or better?
-Is depreciation less than 10% of gross profit? -Do they have interest expenses that are less than 10% of operating income?
-Is the company's net income on a historical uptrend looking at the past 5 years?
-Over the past 5 years has the company been historically generating cash and equivalence?
-Does the equation “total current assets minus total current liabilities” equal a positive number?
-Does the equation “total current assets divided by total current liabilities” equal 1 or greater?
-Is the “property/plant/equipment” cost a small percent of gross profit?
-Return on total assets= net earnings divided by total assets. Does the company have a high percentage return?
-Return on shareholder’s equity= net income divided by shareholders equity. Does the company have a return of 15% or better?
-Has the company over the past 5 years shown a consistent growth in earnings per share?
-Has the company spent a small portion of it’s income on capital expenditures? Go back 5 years and add up all capital expenditures and divide it by the total net income for the same period.
Using this checklist you should be able to fairly accurately grade the stocks you are thinking about buying, and increase your chances of buying a company that has a good chance of sticking around and providing you a nice return on your investment over time.
