Don't spend time analyzing stupid stocks. Here are five tests you can use to help you rule out bad stock candidates so that that you can devote more time researching worthwhile ones.
All the data you need is available in one place: Yahoo's new Key Statistics report. Get there from Yahoo's main finance page (www.finance.yahoo. com) by getting a price quote and then selecting Key Statistics from the left menu.
Remember, eliminate any stock that doesn't pass all five tests.
Valuation: It's easy to get caught up in the excitement of a company's growth prospects and overpay for its stock. That's why valuation should be your first check. Price/earnings ratio, which is the recent share price divided by 12-months-per-share earnings, is the most commonly used valuation measure.
The acceptable P/E depends on the stock's expected earnings growth. As a rule of thumb, most stocks trade with P/Es around 50 percent higher than their forecast annual earnings growth.
For example, a 15 P/E would be considered reasonable for a company expected to grow earnings around 10 percent annually.
However, a company expected to grow earnings at a 30 percent rate would command a 45 P/E.
Yahoo's PEG factor compares the P/E (based on the current year's forecast earnings) to the forecast earnings growth. A PEG of 2 means that the P/E is twice the expected growth, while a PEG of 1 means that the P/E equals the expected growth rate.
So my suggestion that the P/E should be 50 percent higher than forecast earnings growth translates to a 1.5 PEG.
Allow a little leeway because my suggested value is only a guideline. Also, very low PEGs, say below 1, signal problems that insiders may know about that haven't yet been reflected in the earnings forecasts.
So avoid stocks with PEGs of 2 or higher, and give preference to stocks in the 1.2 to 1.5 range.
Sales: A company has to sell something to earn money. You're buying an idea, rather than a going concern, if your candidate isn't racking up significant sales revenue. Don't fall for a story with no substance. Yahoo lists the last 12-month's revenue under Income Statement. Require at least $50 million, and more is better.
Profitability: Profitability ratios measure how efficiently a firm is using its assets to generate earnings. Return on equity is the most widely followed profitability ratio. It's computed by dividing net income by shareholder's equity (book value).
Many professional money managers avoid stocks with ROEs below 15 percent. Yahoo lists return on equity under Management Effectiveness.
Go with the pros and stick with minimum 15 percent ROEs, and higher is better.
Cash flow: A company's reported earnings are subject to myriad accounting decisions involving depreciation schedules, revenue recognition policies and the like.
By contrast, beginning and ending bank balances are readily measured, and not subject to interpretation. That's why many experts view operating cash flow, the amount of money that flowed into, or out of, a company's bank accounts, as a more accurate performance measure than reported earnings.
Many times, a company that reported positive earnings actually lost money when you count the cash. Companies with cash flowing out instead of in will eventually run out of it, and will have to raise more cash by selling stock or borrowing. Either of these events is bad for shareholders.
Yahoo lists cash flow from operations under Cash Flow Statement.
Avoid companies with negative cash from operations.
Debt: High-debt companies are more problematic than those with little or no debt. Most experts expect interest rates to rise as the economy recovers. Higher interest rates translate to higher debt-service costs and reduced profit.
Further, an unexpected sales slowdown could reduce earnings and make debt servicing difficult.
Some companies are better equipped than others to handle such events. However, figuring out which companies are faring well and which aren't means getting intimate with financial statements. It's easier to avoid the problem by sticking with low-debt stocks. Yahoo lists two important debt measures in its Balance Sheet section.
The total debt/equity ratio compares the total of a firm's short- and long-term debts to shareholders equity (book value).
The higher the ratio, the higher the debt. Ratios below 0.5 signify low debt, and ratios above 1.0 reflect high debt. Stick with D/E ratios below 0.5, and lower is better.
Current ratio compares a firm's current assets such as cash and inventory with its current debts, which are obligations that must be paid within a year. Unlike D/E, when evaluating current ratio, higher is better.
Ratios below 1 indicate that current liabilities exceed current assets, which is bad. Stick with 1.5 or higher current ratios, which means that current assets exceed current liabilities by at least 50 percent. Passing these tests means that a stock is worthy of further research, not that you should buy it.
