The 4 Fundamentals of Stock Picking

11/10/2011 6:30 am EST

Focus: STOCKS

Patrick McKeough

Editor, Successful Investor

When you’re looking for bargain stocks, it’s best to focus on shares of quality companies that have a consistent history of sales and earnings, as well as a strong hold on a growing clientele, observes Pat McKeough of TSI Network.

High-quality bargain stocks like these are rare and hard to find, even when the markets are down. But when you know what to look for, you can discover them. We use these three financial ratios as a guide to spotting them:

Price-to-Earnings Ratios
The P/E is the ratio of a stock’s market price to its per-share earnings. As a rule, the lower the P/E, the better. Generally, a P/E of less than ten represents excellent value.

We calculate each P/E ratio using the most recent financial data. But we also analyze the “quality” of the earnings. For instance, we disregard a low P/E ratio if it is due to a one-time capital gain on the sale of assets, since the gain temporarily bloats the “E." (That shrinks the P/E.)

Similarly, we add back any one-time earnings write-offs, so we don’t miss out on bargain stocks that would have had low P/E ratios if not for one-time write-offs.

You need to remember that a low P/E can be a danger signal. A low share price in relation to earnings may mean earnings are falling or about to fall. That’s why it’s crucial to view P/E ratios in context. Instead, we check to see if other financial ratios confirm or contradict their value.

Price-to-Book Value Ratios
The book value per share of a company is the value that the company’s books places on its assets, less all liabilities, divided by the number of shares outstanding.

Book value per share gives you a rough idea of the stock’s asset value. This ratio represents a “snapshot” of an instant in time, and could change the next day.

Asset values on a company’s books are the historical value of the assets when they were originally purchased, minus depreciation. (Certain types of assets on a balance sheet might have actual market values well above historical values, as sometimes happens with real estate or patents.)

When we find a stock with a low price-to-book value, we look to see if the price is too low, or if its book value per share is inflated. Often, we find that the stock price is too low. But, sometimes, the company’s assets are overpriced on the balance sheet, and at risk of being written down.

Price-to-Cash Flow Ratios
Cash flow is actually a better measure of a company’s performance than earnings. While reported earnings are subject to accounting interpretation and can be restated in later years, cash flow is a measure of the cash flowing into a company less cash outlays.

Simply put, it’s earnings without taking into account non-cash charges, such as depreciation, depletion, and the write-off of intangible assets over time.

Cash flow is particularly useful in valuing companies in industries in which depreciation and depletion charges are based on the historical value of assets instead of current values—industries such as oil & gas and real estate. As with any financial ratio, you have to look at it in context.

The Final Factor
Look at the quality of the company’s business. Once we’ve found a company that looks attractive using the financial ratios detailed above, we look to see if it has a solid business in an attractive industry, with a history of sales and earnings, if not dividends.

Even a stock with attractive financial ratios can stagnate if the company or its industry is in a difficult period. But if it’s a high-quality company, it’s likely to hold up better than other value-priced alternatives. Moreover, it may be first to move up when conditions improve.

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