How To Pick Stocks: 5 Best Stock Investment Strategies

It is important to do your homework if you want to try your hand at stock picking. The goal is to find a good price – especially if you plan to hold the stock for some time. To determine if a stock is viable and if it deserves a place in your portfolio, do thorough research before putting all of your capital into it. 

By making this purchase, you become a part-owner of a company. Investors should do the necessary research. 

In this article, we will go over the five strategies most smart investors use to make money in the stock market.

1. Value A Company

In theory, every investor wants to buy low. We all understand bargains, and we all prefer buying products on sale rather than at full price. But buying low and selling high isn’t as easy as it sounds, because buying low often means diving in while everyone else scrambles to get out of the water. After all, they wouldn’t all be leaving unless someone had seen a shark, would they?

The buy low, sell high strategy works better if you focus not on the market, but on a specific stock. If you can determine on your own whether a stock is cheap, you can muster up the fortitude to buy it regardless of the state of the broader market.

Study after study has shown that stocks with low valuations tend to outperform. With those decades of research in mind, here are some valuation ratios to consider:

• Price/earnings ratio. 
• Price/sales ratio.
• Price/book ratio. 
• Price/operating cash flow ratio.

While investors can calculate dozens of valuation ratios, the four listed above require statistics anyone can gather at no cost, and all four can help you assess a stock’s value.

To get started, prepare a spreadsheet or printed page to keep all the data in one place. You can access all the numbers you need from a free website such as Yahoo! Finance.

Price/Earnings Ratio

The price/earnings ratio is the most popular valuation metric, cited often by professionals and amateurs alike. Earnings, or profits, represent what a company has earned after it pays its bills. Valuing a company relative to its profits makes sense. 

After all, don’t you want to generate the maximum profit for every dollar you invest? When you purchase a share of stock, you acquire a tiny piece of a company’s earnings. And what the market will pay for those earnings tells you a lot about the company.

To calculate the price/earnings (P/E) ratio of a particular stock, you’ll need the stock’s share price and its earnings over the last four quarters—often called 12-month trailing earnings. Companies report earnings four times a year, with most—including Pizer—breaking the year down into the three-month periods ending March, June, September, and December. (Some companies report in January, April, July, and October, or February, May, August, and November.)

Visit your preferred financial website, type in the ticker symbol for the stock you wish to analyze, and seek out historical earnings data on the page containing information on earnings estimates. Most pages with estimates will list earnings for the four most recent quarters. 

Simply sum the earnings per share for those four quarters, and you have trailing 12-month earnings per share. For example, Pizer traded at $28.21 per share at the end of August 2013 and earned a total of $2.10 per share in the last four quarters, or the 12 months that ended in June. Divide the share price by per-share profits, and you get a P/E ratio of 13.4.

After you calculate the P/E ratio, do the same for other companies in the same industry. You can’t just pick other companies randomly, because P/E ratios vary from industry to industry. For example, oil refiners have traded at low P/E ratios for decades. 

Software companies, on the other hand, tend to command higher P/E ratios than the average stock. If you compare a software company to a refiner, the refiner will almost certainly look cheaper—even if that refiner trades at a far higher P/E ratio than its peers. However, that refiner may not actually represent a better value.

Suppose you select a refiner that trades well above the typical valuation for its industry, and you select a software company that’s among the cheapest in its group. Even with a higher absolute P/E ratio, the software company might represent a superior value. Before you make that determination, perform a peer-group valuation comparison and also review the stocks’ growth, profitability, and other factors.

In Pizer’s case, comparable stocks include Merck, Eli Lilly, and Bristol-Myers Squibb. Be careful when selecting competitors for comparison. When possible, you want companies that operate in the same markets as your target and which also compete in the same weight class. 

In other words, if you want to analyze Pizer relative to other drug companies, select the biggest ones you can find. As the table illustrates, Pizer trades roughly in line with two of its largest peers— based on P/E—but looks much cheaper than Bristol-Myers Squibb.

While the traditional P/E looks backward, you can also use the ratio to look forward. P/E ratios that use estimates provide another view of the company, one that hints at a story you won’t hear from valuation ratios relying on historical numbers. 

Instead of dividing the share price by earnings over the last 12 months, use the estimate for profits in the current fiscal year or the next year. You can find these estimates on any of the financial websites mentioned earlier.

For instance, Pizer is expected to grow per-share profits 5% this year and 4% next year. For the most part, analysts don’t expect much growth from the big drugmakers. Not surprisingly, since earnings represent the denominator of the P/E ratio, rising earnings will equate to a lower ratio. 

As of August 2013, Pizer traded at 12.8 times the profit estimate for 2013 and 12.2 times the 2014 estimate. Pizer looks somewhat cheaper relative to its peers based on the P/E ratio using the 2014 estimate than it did using trailing profits.

While the P/E ratio effectively gauges value for most companies, it’s not perfect. When you consider a company’s P/E ratio, keep the following points in mind:

Price/Sales Ratio

The price/sales (P/S) ratio focuses on the topmost line of the income statement. Sales also called revenue, reflect the amount of money a company receives before taking expenses into account. 

As a raw measure of performance, sales won’t tell you as much as profits will. Companies can spend heavily to boost sales, while inefficient operation squeezes little income from that revenue. 

However, studies show that the P/S ratio is also an effective predictor of future performance. Stocks that are cheap based on P/S ratios tend to outperform more expensive stocks—not unlike the relationship between performance and P/E ratio.

To calculate the P/S ratio, start with the numerator. You can collect sales data on the same website where you grabbed the earnings numbers. Find the link for the income statement and add up the sales for the last four quarters. Multiply the stock’s price by the number of shares outstanding—this will give you the stock-market value, or market capitalization. 

Divide that number by total sales from the last four quarters to derive the P/S. Like P/E ratios, you can then compare the performance of the company in question with others in the industry. For example, Pizer traded at 3.7 times sales at the end of August 2013—pricier than Merck and Eli Lilly, but cheaper than Bristol- Myers Squibb.

Here are some other issues to consider while analyzing a company’s P/S ratio:

• The ratio works for just about every company. While many firms post negative earnings or cash flows, just about all of them have positive sales. When no other ratios work, you can often turn to the P/S ratio for help.
• While sales vary from quarter to quarter and will certainly rise and fall with economic cycles, they don’t usually fluctuate as much as other statistics. For that reason, the P/S ratio makes sense for stocks in industries sensitive to cycles, such as companies that sell industrial goods, discretionary consumer products, or semiconductors. Companies’ customers buy more during good times and less when their own situations get dicey. Sales will ebb and flow with that demand, but they generally hold up better than earnings or cash flows.
• Accounting rules for sales offer less leeway than the rules for calculating earnings. As such, the P/S ratio is less susceptible to manipulation by accounting than the P/E ratio.

Price/Book Ratio

While both the P/E and P/S ratios compare the stock’s price to statistics from a company’s income statement (also known as the profit and loss statement), the price/book (P/B) ratio draws on the balance sheet. While income and cash-low statements report quarterly numbers that will combine to reflect annual performance, balance sheets simply take a snapshot of the company at a particular time.

To calculate the P/B ratio, divide the stock’s market capitalization by the book value, or equity. For example, at the end of August 2013, Pizer traded at 2.6 times book value—the lowest among the four-drug stocks in the table. 

You’ll find the book value on the balance sheet. But instead of summing the equity for the last four quarters, just use the most recent period.

Equity represents assets minus liabilities. In other words, if a company owns $10 billion in assets, and also owes $5 billion, it has $5 billion in equity. Equity—sometimes called shareholders equity or common equity—should reflect the company’s liquidation value in theory. If the company goes bankrupt and sells its assets to pay its creditors, it should be left with assets that equal the equity balance.

Of course, because of accounting rules and other factors, book value only estimates liquidation value, and for most companies, the estimate would be very rough. The book value of an asset reflects its original cost and may not keep pace with changes in the asset value, either because of inflation, depreciation, or a change in the asset’s ability to generate revenue.

That said, the P/B ratio still serves as a useful check of other valuation methods. A stock cheap on P/E and P/S should probably look good based on P/B as well. This won’t always occur, but a discrepancy between multiple valuation ratios should raise a lag. In other words, if the stock sports a low P/E but trades at a premium to its peers on P/S and P/B, you’d be wise to learn the reason why before you buy it.

Consider the following when analyzing P/B ratios:

• Only a few companies have negative equity values, which means you can use the ratio with more companies than you can with the P/E ratio.
• P/B works best with traditional businesses that own hard assets —things like factories, machinery, and warehouses full of inventory. Accounting rules also tend to keep equity from fully reflecting the value of intangible assets like patents and other intellectual property. For companies with most of their value tied up in brand names and other intangible assets, book value has little in common with the intrinsic value of the company.
• For companies with extremely heavy debt loads—or ones that have posted serious enough losses to erode the value of equity— the P/B ratio can appear inordinately high.

Price/Operating Cash Flow Ratio

Many investors view the price/operating cash flow (P/OCF) ratio as the best of the four valuation ratios—and they may have a point.

Remember how companies can skew reported earnings using accounting tricks? Cash flow doesn’t leave them many loopholes. 

To calculate operating cash low (don’t worry, you can pull the final data from the Internet without calculating it yourself), companies start with earnings and then strip away costs that aren’t paid in cash as well as other non-cash adjustments. Operating cash low—also called cash from operations—reflects the amount of cash a company’s operations generate.

While aggressive accounting methods can skew earnings (and to a lesser extent, sales), and book value becomes less accurate over time, the P/OCF ratio probably offers the cleanest, most accurate picture of a company’s valuation. When a company grows earnings but doesn’t grow cash low, investors should become suspicious. If a stock you’re considering looks cheap based on the P/E ratio, but expensive on P/OCF, the company might have resorted to accounting shenanigans to boost earnings and make its growth look stronger.

To calculate the P/OCF ratio, divide the stock-market value by the operating cash flow generated over the last four quarters. You’ll find operating cash low in the statement of cash lows presented online, again summing the last four quarters. For example, at 12.3 times operating cash flow, Pizer is cheaper than one of its peers and more expensive than two others.

When you use the P/OCF, remember these points:

• Plenty of companies generate negative cash lows, rendering the ratio useless.
• Many companies don’t report cash-low data—at least not in a way that is accessible to beginning investors. In particular, banks and utilities tend to skimp on providing that kind of information.
• Not all companies calculate cash flow the same way internally. While federal accounting rules provide guidelines, many companies present their own customized numbers in addition to those mandated by the government. When you compare companies using P/OCF, make sure you collect similar numbers for the different companies. Your best option is to pull the data directly from the statement of cash flows—not from the text in a company’s earnings release.

Importance of Valuation

Value remains arguably the most popular approach for analyzing stocks, and research suggests it’s the most important determinant of stock performance. Stocks with low valuation ratios of all types tend to outperform. However, in the investment world, “tend” is a big word, and by no means implies any kind of certainty.

When studies conclude that stocks with low P/Es tend to deliver higher returns than those with high P/Es, they generally combine data from thousands of stocks and holding periods. When you look at a smaller sample—say, one stock—the trend doesn’t always apply. 

Some stocks with high valuations will perform quite well, and some stocks with low valuations will underperform the market. This often occurs with stocks that trade at a discount to their peers because of weakness somewhere else.

You can’t own every stock, and you won’t find all the winners. You also can’t avoid all the stinkers. You just need to find enough winners to offset your losers, and you can increase your success rate by looking at other attributes besides value.

2: Calculate Growth Rate

Over time, you want your stocks to increase in value. If the market values stocks relative to operating statistics such as sales and earnings, what will it take to drive up the price? Higher sales and earnings. 

Can stocks appreciate at price without generating growth? For a while, yes. But without growth, eventually, those gains will dry up —and sometimes “eventually” means “just about now.” You can never be sure when the market will lose patience with a company that no longer grows. For this reason, investors tend to prefer companies that know how to grow.

For example, suppose Acme Widget generated $6 billion in revenue and $1 billion in profit last year. If the stock trades at 2.5 times last year’s sales and 15 times earnings, it has a market capitalization of $15 billion. 

With 1 billion shares outstanding, the shares cost $15 apiece. If Acme posts the same revenue and profit this year and the valuation ratios remain the same, how much will the stock appreciate in value by the end of this year? 0%.

On the other hand, what if Acme invests its cash wisely—in new equipment to broaden its product line, and markets the new goods to its existing customers—boosting sales and profits by 20%? Once again, assuming the P/E and P/S ratios don’t change, the company’s share price will rise to $18, a tidy 20% gain. Of course, these numbers represent an ideal situation. Sales and profits rarely grow at the same rate, and valuation ratios rarely remain steady for long periods of time.

Companies report operating results on a quarterly basis, and disclose their performance via the media in an earnings release. Investors should read the earnings releases of every stock they own, as well as those of stocks they’re considering for purchase. While some companies pack their releases with information and others keep the document sparse, they all present the basics: sales, profits, and share counts.

To view these releases, visit the company’s website and seek out the investor relations (IR) section. Some companies make it tough to find their corporate information, but once you locate the IR page, you shouldn’t have any trouble downloading the earnings releases and filings with the Securities and Exchange Commission (SEC).

Why mention earnings releases now? Because to assess a company’s growth in detail, you’ll need to gather some numbers from those releases and SEC filings. Not all growth statistics tell the same story. As a conscientious investor, insist on learning as much of the tale as you can upfront. Taken in combination, the following six growth numbers will reveal much about a company:

• Quarterly growth.
• Trailing 12-month growth.
• Four-year annualized growth. 
• Estimated current-year growth. 
• Estimated next-year growth. 
• Estimated five-year annualized growth.

As with valuation, try to compare the stock’s growth to the same numbers for similar companies in the same industry. Remember that stocks with faster growth tend to command higher prices as measured by such valuation ratios as P/E. Start by picking a company, preferably a large, strong one that’s been around for a long time. Next step? Read the growth story.

Collecting Relevant Data

In your company’s growth story, consider quarterly growth the first sound bite. You can obtain data for the latest quarter—and indeed the last four quarters—from your financial website of choice. 

Ultimately, the goal here is to calculate year-over-year growth rates, and you won’t find the older material in the same place you found more recent numbers. Now it’s time to visit the company’s website to pull the rest of the data.

Start with the earnings release for the quarter a year before the latest one. Read the release from the top until the company tells you how much it earned in the quarter. Here you must be careful, because the first number you read may not be the one you need. 

Don’t just grab the release for the previous quarter. Comparing June-quarter earnings to March-quarter earnings may be beneficial, but many companies operate seasonal businesses. Year-over-year comparisons (quarter ended June 2013 versus the quarter ended June 2012) generally provide greater insight into growth patterns. 

Companies often exclude things from their earnings. For example, a manufacturing company might exclude the money it spent to settle a lawsuit or the gain made by selling a factory. You might hear these exclusions called unusual items, special items, or extraordinary items. 

If the company says it excludes these items from its earnings, the analysts who follow the company probably do the same (and so should you). Most companies that exclude items from their earnings will present the adjusted profit number in a table. However, some companies will make you do the calculations. If all this sounds like work, you heard right. 

Remember, if investing were easy, everyone would do it, and everyone would develop confidence in their stock analysis. But don’t worry, the job isn’t as though it sounds—and the actual math is simple.

As long as you’ve got the earnings release in front of you, grab the quarterly sales numbers as well. Don’t worry, you won’t have to exclude anything from sales.

Calculating operating cash low requires some extra steps. For one thing, not all companies present a statement of cash flows in their earnings releases. If yours doesn’t, you’ll have to dig a little deeper and check out the SEC filings. Just about every company will either provide the filings on their own website or offer links to a third-party site that stores them. To obtain quarterly data, access Form 10-Q.

After you collect the cash-low data for the year-ago quarter, you’re nearly there. To finish the job, download the earnings release or 10-Q from the quarter immediately before the one you just checked. For instance, if you’re looking at the June quarter, pull the March-quarter numbers as well.

While Yahoo! Finance presents cash flows from the four most recent quarters in a quarterly format, most other websites—as well as official statements of cash flows prepared by the companies themselves— present data progressively. In other words, if a company generates $100 million in operating cash flow in the first quarter and $80 million in the second quarter, the second-quarter statement of cash lows will list an operating cash flow of $180 million—the sum of the first two quarters. 

Unless you start out with the cash flow for the first quarter of a company’s fiscal year, you’ll need to subtract the value from the previous quarter’s statement to obtain a true quarterly number.

Now that you have enough data to calculate the most recent quarter’s growth, next up is trailing 12-month growth. Essentially, repeat the previous steps—find quarterly earnings, sales, cash low, and prior-year earnings data—until you’ve collected four quarters, worth of data for each statistic. Sum the quarterly numbers, and you have all you need to calculate trailing 12-month growth.

Now collect the data necessary for calculating four-year annualized growth. While calculating four-year growth requires you to go even farther back, annual data requires a lot less work to obtain.

To collect per-share earnings data, download company earnings releases for the fourth quarter of the last fiscal year and for the fourth quarter of the fiscal year from four years earlier. For instance, if the company’s last fiscal year ended in 2012, you’ll need annual data from fiscal 2008. Find the numbers that exclude all the special items, then record those profits.

Sales and cash flow are even easier. For this stage of the process, visit money.msn.com/investing. Why the MSN site? Because it provides five years of annual data, which neither Yahoo! Finance nor Google Finance does.

Start with the income statement. Choose the option for annual data and grab the sales numbers. After you’ve gleaned your sales data, move to the cash-low statement for operating cash flow. Now you’ve collected all you need for the historical growth rates.

Last, you can find everything you need for the estimated current- year, estimated next year, and estimated five-year annualized growth rates in one spot.

Visit the analyst estimate page for your stock at Yahoo! Finance or MSN Money and select the following numbers:

• The per-share-profit estimate for the current fiscal year. 
• Estimated per-share profits for the next fiscal year. 
• Per-share profits for the last fiscal year.
• The growth rate for the next five years.

After you have collected all of these numbers, stop for a minute and pat yourself on the back. You’re not done, but the most time-consuming job is behind you. You’ve already tackled more stock analysis than most investors ever will. Finish doing your research on a few stocks, and you won’t be a beginner for long.

Calculating Growth Rates

Now all that remains is the math. Before you begin, review the data for three possible problems.

1) Negative numbers. You need two statistics to compute growth rates—the most recent period and the historical period—and your calculation won’t mean anything if either of those numbers is negative. You might still be able to draw some conclusions, though. For example, if a company moves from negative earnings or cash flow to positive, that’s good news—your stock has gone from a loss to a gain. If a company moves from negative earnings or cash flow to a smaller loss (in other words, from –$1.00 per share to–$0.50 per share), that’s often good news as well—your stock has narrowed its loss. Of course, if the loss widens or the stock goes from a profit to a loss, the news has gotten worse.

2) Blanks. Perhaps you selected a company that hasn’t been around long enough to provide all the needed historical data points. Some companies don’t have profit estimates, and if you went with a utility or a financial company, you might not have any cash-low data. If you can’t find any of the numbers needed for a certain calculation, don’t try to shoehorn the data you do have into a modified result. Just forget about calculating that growth rate.

3) Magnitude. Did you get all the numbers right? If your numbers show a company generating sales of $520 million last year and $48 million the year before, you might want to double-check and make sure you didn’t add a zero to last year’s sales or leave a number off the previous year’s. Sometimes sales really will jump 983%, but not very often. If you actually meant to record $480 million (instead of $48 million) for year-ago sales, the growth rate falls to 9.8%, a far more reasonable number for most companies.

To calculate the growth rate, first, divide last quarter’s sales by sales from the year-ago quarter, then subtract 1.

Equation

Growth rate = (sales in most recent quarter/sales in the same quarter a year ago) – 1

Pizer example: ($12,973 / $13,968) – 1 = –0.071 = –7%

For Pizer, that calculation yields a growth rate of negative 7%, meaning that sales fell. Repeat this step for your remaining data from the last quarter as well as the trailing 12 months to come up with trailing 12-month growth.

Annualized growth rates break down long-term growth into one-year chunks. Suppose a stock generated $500 million in sales in 2002 and $740 million in 2012. Those numbers equate to an annualized growth of 4% over the 10-year period. If you start with sales of $500 million in 2002 and increase them by 4% each year, by 2012 sales will have grown to $740 million. 

Of course, operating results don’t move in a straight line. Don’t assume that a stock with 4% annualized sales growth actually grew its sales by 4% each year. The numbers certainly varied from year to year. However, given sales for two periods more than a year apart, calculating annualized growth rates can give you a sense of a company’s overall trajectory.

To calculate, start by dividing sales in the most recent year by sales four years ago. Next, raise that number to the power of 0.25, or one-fourth. Last, subtract one. With Pizer, this equation reveals an annualized growth rate of 5%.

Equation

Annualized growth rate = (Sales in last fiscal year / Sales from four years ago) ^ (1 / number of years) – 1

Pizer example: ($58,986 / $48,341) ^ (1/4) – 1 = 0.051 = 5%

To calculate estimated profit-growth rates for this year and next year, use the equation for quarterly growth above—the one without the exponent—only this time, put profits for the later period as the numerator and profits from the earlier period as the denominator. Since the estimated growth rates only span a single year, you don’t need to annualize.

Equation

Estimated profit growth rate = (Profits for later period / Profits for the earlier period) – 1

Pizer’s estimated current-year per-share-proit growth: ($2.21 / $2.19) – 1 = 0.010 = 1%

Pizer’s estimated next-year per-share-proit growth: ($2.31 / $2.21) –1 = 0.044 = 4%

That leaves just one growth number—the five-year profit-growth estimate. This one requires the least work of all; you already collected it from Yahoo! or MSN, and no calculations are necessary.

Comparing Growth Rates

Now that you’ve gathered your data and computed your growth rates, what should you do with them? Try a three-step process.

1) Compare the growth rates of different statistics for the same period. For the most recent quarter and for the trailing 12 months, Pizer managed per-share-profit growth of at least 17%. However, sales and operating cash low declined during both periods. This disparity suggests that Pizer’s core business isn’t growing, yet somehow the company has managed to wring more profit out of its declining base of revenue. 

What is the most likely cause for such a trend? Gigantic cost cuts that fattened profit margins. And while increasing efficiency is generally a good thing, companies that can’t generate growth by bringing in new business or creating new products will often cut deep into their cost structure—sometimes so deep that they further hinder their ability to grow the business.

The four-year annualized growth rates tell a different story, but not necessarily a better one. Pizer’s sales rose by $10 billion over the previous four-year period, managing annualized growth of 5%. But profit growth was sparse, and operating cash flow declined. These numbers suggest Pizer’s struggles with growth didn’t just arise in the last year.

Profit estimates suggest Wall Street analysts don’t expect much growth from Pizer, targeting profit expansion of 1% this year and 4% next year. The five-year picture doesn’t get much brighter, with the consensus calling for annualized profit growth of 5% over the next five years. That said, modest growth expectations aren’t always bad news. The lower the bar, the easier it is for a company to jump over it. While the stock market definitely likes growth, it loves companies that grow faster than expectations.

2) Compare the growth rates of the same statistics over different periods. Pizer’s per-share earnings have jumped over the last year, but evidence suggests you can’t necessarily count on that growth continuing. With annualized growth of 1% over the last four years and expected growth of 5% over the next five, the recent jump looks more like a blip than a trend—a pocket of strength soon to be sewn shut.

Pizer’s sales growth doesn’t lend itself to interpretation as clearly as profit growth. The numbers indicate decent growth in recent years, with a major slowdown recently. Such a digression warrants a little extra research if Pizer makes the cut based on the rest of your analysis.

Operating cash low tells a cleaner story. It was down slightly over the last four years and down over the last quarter and year. Does anything in those numbers indicate that Pizer’s cash-generating ability should improve going forward? 

Not really, and this latest conclusion should point you back a few paragraphs to the mention of companies that grow faster than expectations. Pizer’s cash-low trend doesn’t offer much cause for optimism about the company’s ability to surprise anyone.

3) Compare the growth rates of the target company with its peers. Pizer and all three of the competitors saw sales decline over the last year, while two posted lower operating cash low. These numbers suggest the decline may have something to do with larger forces across the entire drug industry, not just Pizer. Three of the four drugmakers still managed to grow profits, suggesting other companies have also chosen to cut costs aggressively to compensate for the lack of growth elsewhere.

At the conclusion of the three-step process to analyze its growth, Pizer doesn’t stand out from the crowd, and Pizer’s growth over the last four years doesn’t impress. However, most of the other drugmakers also managed feeble or inconsistent growth. Pizer ranks in the middle of the pack for both growth and estimated growth. Growth-oriented investors might find more to like the other stocks, though all have glaring weaknesses.

Once you’ve answered the question of whether or not your company can grow, another query crops up: Does your company know how to grow efficiently?

3. Measure Profitability

Any company can increase sales if it spends enough money on advertising, marketing, or expansion efforts. But if a firm requires $100 million in expenditures to generate $80 million in new revenue, it may as well not have bothered.

Anyone who has struggled to operate a household on a budget constrained by his income understands the need for profitability. If you can reduce your costs by eating at restaurants less often, switching to a cheaper cable-TV plan, and refinancing your mortgage, you might save enough to pay for that family vacation to Orlando this winter.

While most companies won’t cut costs to fund a visit to Disney World, they have other reasons to tighten the belt, and they follow a similar approach as a household. As individuals on a budget, companies start by identifying unnecessary expenses, then move on to expenditures that may help the company but not enough to actually benefit the bottom line.

For example, what if laying off 70 people or closing that old factory can cut operating expenses to 41% of revenue from last year’s 42%? That half a percent dip in the expense ratio doesn’t sound like much, but at the corporate level, where numbers get big, small cuts can mean a lot. 

For a company with $1 billion in annual revenue, the previous expense reduction would free up $10 million for a marketing campaign, product research, or bolstering the bottom line. Those profits matter, and not only because investors value companies relative to profits. 

By cutting costs or otherwise boosting efficiency, companies can squeeze more profit growth out of their existing resources. Are sales not rising fast enough to suit investors? Judicious cost cuts can keep profits growing faster than revenue—at least temporarily.

While improving profitability alone doesn’t make a company a good investment, it does suggest both a willingness and an ability to keep expenses under control. For within reason, gains in profitability point to committed, competent management.

Of course, you want your companies to at least hold the line on profitability and preferably improve. But moderation is important. Remember the household saving for the Disney trip? What if, instead of cutting back on restaurant visits, the family just slashed its food budget in half? In order to subsist on half of the money, a family that routinely purchased milk and fresh fruit and vegetables might resort to serving nothing but cheap, starchy foods. 

Sure, costs would go down, but ultimately at the cost of good health. Companies operate in a similar way. Retailers that trim costs by purchasing low-quality goods, drugmakers that skimp on research, or oil companies that stop spending on exploration can become more profitable quickly. Of course, those cuts can also limit the companies’ ability to grow revenue and profits going forward.

Gauging Profitability Trends

Even more than growth rates, profitability varies widely from industry to industry. For instance, grocery stores are known for their low-profit margins. Like most retailers, grocery stores buy their goods wholesale and mark them up for sale to retail customers. 

But because of intense competition and consumers’ lack of store loyalty, supermarkets must take care when pricing their products. 

Factor in the costs of operating the stores and paying employees, and most grocers have little margin for error. The five largest U.S. grocery-store stocks average net profit margins of just over 2% of sales. In contrast, software titan Microsoft’s net margin tops 25%.

Does this mean investors should buy Microsoft and stay away from Kroger? Not necessarily. Low profitability is a way of life in the grocery business, but that trend is not new, and the market values these stocks accordingly. 

For a company with a 2% profit margin, a rise to 2.1% can spark impressive profit gains. Just like valuation ratios and growth rates, shrewd investors will consider a company’s profitability as it compares to similar companies.

Not only does profitability vary from industry to industry, but it can vary from quarter to quarter as well, exhibiting the seasonality discussed in the section on growth. Once again, department store chain Macy’s illustrates the point.

Macy’s generates much higher profit margins during its busiest period—the January quarter. Quarterly margin data shows Macy’s increased its net margin in two of the four quarters of its 2013 fiscal year, while the margin eroded during one quarter. 

The trailing 12- month margin—which considers four quarters of data—explains the trend more clearly. The department store’s profitability increased sharply during the fiscal year that ended in January 2012, then hit a plateau in the spring and summer of 2012 before declining at the end of the year.

Of course, changes in profitability from quarter to quarter do have some analytical value, but unless an investor has unlimited time, he should focus his analytical efforts on the most beneficial strategies. For the most part, your profitability analysis should revolve around data for 12-month periods. Investors measure profitability using two sets of ratios:

• Profit margins measure profits (often called earnings or income) as a percentage of revenue—another component of the income statement.
• Returns on assets, invested capital, and equity compare profits to items on the balance sheet.

You can gather the data you need to assess profitability for most stocks from financial websites and the companies’ earnings releases. However, for a few companies that don’t provide balance-sheet information in their quarterly releases, you’ll need to visit the SEC filings.

Analysis of the Margin

Profit margins measure operating efficiency and show how much of a company’s sales it keeps. Taken individually, profit margins may not tell you much. In context, margins and other profitability measures offer plenty of insight.

Margins track a company’s efficiency from sales to profits, allowing investors to find weak points. We’ll focus on three types of profit margins: gross, operating, and net.

Have you ever wondered why profits are often referred to as “the bottom line?” One glance at an income statement will answer the question. At or near the bottom of the document you’ll find a line called “net income” or “net profit.” Travel upward from net income and you’ll strip out costs, one by one, but you won’t find any other costs below net income. It is literally the bottom line.

Net profit margin shows how much of a company’s revenue it gets to keep after paying all the bills. To calculate net margin, you’ll need data for net income and sales. If the company provides net income excluding special items or discontinued operations, use that number. Otherwise, stick to the true bottom line.

Yahoo! Finance and similar sites provide four quarters of history, so you can tackle the irst computation using just the finance site. However, acquiring numbers for the three earlier periods will require a quick stroll through the company’s earnings releases.

For the irst calculation, sum the net income from the four most recent quarters, and then divide it by the sum of sales from the four most recent quarters.

Equation

Net margin = Net income / Sales

Honeywell example: $3,188 / $37,944 = 0.084 = 8.4%

To determine Honeywell’s net income during the year ended June 2013, sum the results from the June 2013, March 2013, December 2012, and September 2012 quarters. To complete your profitability analysis, you’ll work backward one quarter at a time. For example: The net income for the year ended March 2013 consists of data from three of the quarters you already used (March 2013, December 2012, and September 2012), plus June 2012. Remember, always compare income for a given period to sales for the same period.

While all margins present variations on the same theme, each iteration tells a different story. When analyzing net profit margin, keep the following points in mind:

• Lots of companies lose money, and you can’t calculate a profit margin when net income is negative.
• If you hear the phrase “profit margin” mentioned without “net” or another word preceding it, the speaker usually refers to net profit margin.
• When net margins change abruptly, be on the lookout for unusual items. Expenditures such as acquisitions and legal settlements frequently skew net income. While most companies will tell you in their earnings releases which items to exclude from per-share profits, many skip the step with net income. To fix this problem, you can manually adjust your net-income data to account for the excluded items.

Operating profit margin takes into account production and operating expenses, but not taxes or interest payments on debt. It shows us how companies manage expenses beyond the factory. Common expense categories include selling, general & administrative (SG&A)—a combination often referred to as operating expenses; research & development; and non-cash costs such as depreciation and amortization.

Most investment professionals consider operating margin the cleanest of the margins and the best for comparing one company to another. Where net income is the bottom line, think of operating income as the middle line. The strength of profit margins as analytical tools lies in their ability to capture profitability at different points along the road from revenue (the top line) to net income.

Most companies’ income statements feature a line labeled “operating income” or some variant of the term. That’s the number you want. If the company offers you an option for operating income excluding discontinued operations, go with it. You can calculate the operating profit margin the same way you tackled net profit margin, just using operating income rather than net income.

Equation

Operating margin = Operating income / Sales

Consider the following when you analyze operating profit margin:

• Companies can exert a lot of control over their operating expenses. As such, changes in the operating profit margin directly reflect choices made by management. Making comparisons between trends in operating margin and trends in net and gross margins can provide hints about the attitude and intentions of company leadership.
• Some companies—though not many—report operating losses. In such cases, rather than try to manipulate the numbers to create a positive value for your margin, just ignore it. For the most part, you won’t want to buy companies with operating losses anyway.
• In a few cases, companies will separate depreciation and other noncash costs, stashing them below the operating-income line. For ease of comparison, subtract them from operating income.

Gross profit margin takes into account only a company’s cost to produce goods. Of course, the concept of production means different things to different companies. Industrial firms might report the cost of sales, or the cost of goods sold, reflecting the funds spent to cover raw materials, labor, and some manufacturing costs. 

Other businesses might use terms like “cost of merchandise” or “cost to provide services.” The consultant Accenture simply uses “cost of revenue.” Fortunately, no matter how a company handles its accounting, you shouldn’t have any trouble finding the numbers you need. You should always be able to find a line labeled something like “gross margin” or “gross profit,” making data collection on this point easy.

To calculate gross profit margin, just duplicate the steps used for the other types of margin, swapping gross profit for operating or net profit.

Equation

Gross margin = Gross income / Sales

When you review stocks based on gross profit margin, keep these points in mind:

Accounting requirements leave substantial leeway at this stage of the income statement. Some companies will include more of their operating expenses than others—potentially rendering cross-company comparisons less valid. If you review the numbers of two companies performing the same service—one with a gross margin of 50% and one at 25%—you may find yourself facing an accounting issue rather than a true disparity in efficiency. If this happens, peruse the expense lines between gross profit and operating profit to check for differences in the way the companies account for their costs.

Unlike operating expenses, production-related expenses tend to be driven by forces outside the company. Possible issues include changes in raw-material costs, issues with a business’s supply chain, and increased maintenance expenses for an aging plant. In many cases, management cannot fully mitigate these problems.

Because of the fungible nature of “production” expenses for companies that don’t manufacture products, cross-company comparisons of gross profit margins should carry less weight in your analysis of such companies. However, regardless of how a company calculates gross profit, comparisons versus historical levels can prove useful.

Some companies—most notably banks like J.P. Morgan Chase— prefer to classify all expenses as operating and don’t report any expenses between revenue and SG&A. In such cases, gross profit and revenue will be the same, which equates to a gross profit margin of 100%. You can’t draw useful conclusions from numbers like that, so rely on operating and net margins instead.

The trailing 12-month profit margins you’ve calculated will help you assess a company’s profitability trends over the last year, alerting you to recent improvements or regressions in efficiency. 

However, near-term efficiency trends mean more within a longer context.

You can glean the numbers you need from the income statement at MSN Money, which provides five years of data. No need to revisit the company website or download more earnings releases.

Returning to Profitability

Do you recall the difference between the income statement and the balance sheet? The income statement moves through time—one-quarter of net income, followed by another quarter of net income until you have four quarters. 

Those four quarters of data combine to paint the operational picture of a year in the life of Honeywell. Balance sheets, on the other hand, don’t rely on four quarters of data to make up a whole year. Balance sheets record assets, liabilities, and equity— values that change over time but never go away.

We can look at balance-sheet returns in two ways: irst, by assessing trends in the last four quarters, and second, by tracking changes that have occurred over the last five years. To perform the second portion of your profitability analysis, you’ll need balance-sheet data for the last eight quarters. 

The first four or five quarters you can obtain via a financial website. But for the oldest quarters, turn to the company’s earnings report. And if your company doesn’t include a balance sheet in its earnings releases, download the 10-Qs.

Returns on assets (ROA), returns on invested capital (ROIC), and returns on equity (ROE) are ratios that function much like profit margins for the balance sheet. 

While profit margins measure how efficiently a company operates by assessing the profit it can distill from revenue in a given period, returns gauge how effectively it squeezes profits out of its existing resources. As is the case with profit margins —operating margins in particular—trends in ROA, ROIC, and ROE serve as a proxy for the quality of company management. 

Differences between industries notwithstanding, bigger is better with these ratios. In a vacuum, an ROA of 8% beats 7%. Declines in ROA, ROIC, and ROE suggest the company has trouble finding profitable investments. Additionally, ROA, ROIC, and ROE mean nothing if a company has lost money. If you come up with a negative ratio, just ignore it.

Return on assets measures a company’s profitability relative to its entire asset base. The higher the return, the more efficiently the company uses its assets to generate profits. At the end of 2012, Honeywell owned $41.9 billion in assets, up 5% from the previous year. For a mature company like Honeywell, investors shouldn’t expect much more in terms of asset growth. Honeywell isn’t building new factories all over the globe. Instead, it’s focused on making the most of its long-term assets—things like property and equipment—and effectively managing current assets like cash, accounts receivable, and inventory.

The size and composition of asset bases vary widely among companies. Businesses that rely heavily on fixed assets like plants and equipment tend to own more assets than technology firms or companies that provide services. Not surprisingly, capital-intensive businesses with higher asset balances tend to generate lower returns on their assets. For example, in 2012, Dow Chemical posted a 1.2% return on assets, while Google managed nearly 13%.

Even within industries, ROA can differ substantially from company to company. Go ahead and do your cross-checks, but don’t be surprised if you see wide variances.

The defense contractors don’t have much variation. Three of the four stocks posted a return on assets between 7% and 8% in each of the last four 12-month periods.

Acquisitions can also throw the numbers off. If a company purchases another one, its asset value will jump—and, theoretically, so should the company’s profits. However, profits don’t always change at the same rate as assets (or invested capital or equity) in the event of an acquisition. 

So if you see a big jump in assets and other balance-sheet statistics without a similarly strong gain in profits, check the news to see if your company has acquired anything big.

To calculate four quarters of ROA, start with the trailing 12-month net income you used for the profit margins. Divide this by the average value of company assets over the last five quarters.

Equation

ROA = Trailing 12-month net income / Average of total assets for the last five quarters

Honeywell example: ($3,188 / $41,413) = 0.077 = 7.7%

The use of a five-quarter average allows the ROA ratio to capture recent changes in the asset base. The average also compensates for cyclicality in such asset categories as cash holdings, inventory, and accounts receivable, which can vary greatly from quarter to quarter. 

Because equity and invested capital are components of assets, the asset balance will always be larger than the other two. As such, a company’s ROA should be smaller than ROIC or ROE.

As you get started with ROA analysis, consider the following:

• Because banks’ balance sheets contain massive amounts of assets, their ROAs always look small. Don’t equate the low ROA to a lack of investment appeal.
• Don’t underestimate the power of a small change. A company with a 2.0% ROA that boosts it to 2.1% managed the same proportional change as one that moved to 21% from 20%.
• While shareholders tend to show more interest in ROIC and ROE than ROA, many companies rely on ROA as a means to track the changing efficiency of their asset use over time.

Return on invested capital—also called return on investment— narrows the focus to assessing how efficiently a company uses the capital it controls. 

While there is no universally accepted definition of invested capital, we can define invested capital as common equity plus long-term debt plus preferred stock plus minority interests. Most preferred stock is, in effect, publicly-traded debt, while minority interests represent third-party ownership of a company’s subsidiaries.

Company managers use ROIC to assess the profitability of divisions within the company as well as to assess the benefits of specific projects. Suppose Acme Widget wants to expand its production capacity, and it can do so by either modernizing an existing factory or building a new one. 

Acme executives might calculate ROIC for each of the possible strategies, and the company would probably pursue whichever project has the potential to generate a higher ROIC. When you use ROIC to evaluate the profitability of a company, you’re adopting the same strategy the company itself may use for its own internal investments.

If your eyes glazed over while reading those last two paragraphs, don’t sweat it. Some investors enjoy digging into the statistics, and good for them. But not everyone wants to deal with that level of detail. You need not become an accounting expert to perform ROIC analysis. You can get by if you know two things:

1) Invested capital reflects the total amount invested in the company by everyone, from shareholders to bondholders to other firms that own a portion of one of the company’s businesses. In effect, invested capital is the amount of skin in the game.

2) You can find all the components of invested capital easily on the balance sheet.

Calculate ROIC by dividing trailing 12-month net income by average invested capital, and calculate invested capital by adding equity, debt, preferred stock, and minority interest.

Equation

ROIC = Trailing 12-month net income / Average of invested capital for the last five quarters

Invested capital = Equity + Debt + Preferred stock + Minority interest

Just as with ROA, start with profits from the last four quarters and the five-quarter average of the balance sheet statistic. You’ll find all four of the components of invested capital on the balance sheet if the company reports them, but not all companies do. 

Additionally, most companies don’t have preferred stock. If the company you seek to analyze does have preferred stock, you should find it near the bottom of the balance sheet in the stockholders’ equity section. 

If the company breaks out common equity as its own line, then add the balance for common equity to the balance for preferred stock. However, many companies don’t provide a separate line for common equity; instead, they lump a variety of values—including preferred stock—together as stockholder equity, shareholder equity, or total equity. 

If your company goes the kitchen-sink route and groups everything together as stockholder equity, just add that bottom number to whatever debt and minority interests amounts you found earlier.

Before you draw any conclusions about investment based on its ROIC, consider the following:

• While most companies calculate ROA and ROE the same way, you can’t assume the same for ROIC. Some versions of ROIC don’t consider preferred stock or minority interest, while others use something other than net profit as the numerator. Don’t accept a company’s calculation of its own ROIC as a number you can compare to the ROIC of its rivals. Calculate your own ROIC for each company.
• Because of massive differences in the asset bases of many companies, ROIC may be the cleanest of the three return statistics to use for company comparisons within a given industry. The concept of profits as a percentage of the company’s available funds to invest makes logical sense.
• If you find a large ROIC discrepancy between two companies with similar ROAs, check their long-term debt. If one carries a substantial debt load and the other does not, then you may have an explanation for the difference in ROIC. Don’t read too much into such differences. You don’t want to overly penalize a company that borrows unless it carries too much debt. How much debt is too much? If interest payments over the last 12 months consumed more than one-third of operating momentum, or if long-term debt exceeds equity, then you may have uncovered a stock that uses too much leverage.

Return on equity is relied on by professional stock analysts more than either ROA or ROIC. Price/book ratios that equity (or book value) consists of assets minus liabilities. Theoretically, if you sold a company’s assets and repaid its liabilities, you would walk away with cash equal to book value. For that reason, analysts consider book value an estimate of a company’s true liquidation value. However, in the context of ROE, it also means something else.

Suppose Acme Widget owns $1 billion in assets. It has financed those assets with $600 million in liabilities, which leaves $400 million in equity. That $400 million represents the book value of common shares outstanding—usually far below their market value—and earnings retained by the company over time.

ROE calculates the return the company earns just on money stockholders has invested. Because equity doesn’t reflect debt or physical assets, ROE represents the most direct assessment of profitability from a shareholder’s perspective. A company’s equity balance reflects its value above and beyond net worth. If a company makes a profit that exceeds the dividends it pays out, that profit adds to retained earnings. As such, consistently profitable companies tend to grow their equity balance over time. To calculate ROE, divide net income by stockholder equity.

Equation

ROE = Trailing 12-month net income / Average equity for the last five quarters

When you assess a company’s ROE, keep these points in mind:

The same weaknesses that affect the price/book ratio also affect ROE. Some companies carry negative balances for equity, rendering the ROE meaningless. If you encounter a company with negative earnings and negative equity—which would result in a positive ROE—resist the urge to calculate it. The resulting number won’t tell you anything.

If you multiply ROE and the retention ratio—or the percentage of earnings a company does not pay out in dividends—you calculate the company’s sustainable growth rate. 

In other words, if Acme Widget has an ROE of 20% and pays out half of its earnings in dividends, it boasts a sustainable growth rate of 10%. While that calculation has laws—among them overestimating the growth of companies that don’t pay dividends—ROE remains a versatile ratio for purposes beyond assessing profitability, including as a proxy for growth.

Because ROE doesn’t take into account debt, it may overstate the profitability of companies that use a lot of leverage.

Annual trends in profitability are the final numbers to consider as we finish up the profitability analysis. You’ll have no trouble gathering data for calculating the numbers including annual ROA, ROIC, and ROE. Just visit the MSN Money site and pull up your company’s balance sheet. There you’ll find five years of annual data.

Equation

ROA = Net income for most recent fiscal year / Average assets for two most recent fiscal years

The only difference in the annual calculation versus one using quarterly results involves the denominator. For annual ROA, divide the income by the average of the last two full years’ asset balances. You can use a similar equation to calculate annual ROIC and ROE—just change the denominator to focus on invested capital or equity.

Profitable Research

None of the preceding profitability ratios presented mean much by themselves. Considered together, they provide a detailed and comprehensive picture of not just your company in question—say, Honeywell—but its position within its industry.

To best interpret the numbers, try this three-step process:

1) Assess your target company’s near-term trends.

In the 12 months ended June 2013, Honeywell’s net profit margin reached 8.4%, up from 6.3% in the year ended September 2012. Operating margin and gross margin followed upward paths as well, with operating margin up to 12.8% from 9.8% and gross margin up to 29.1% from 26.3%. 

All three margins rose more between the September 2012 and December 2012 periods than they did between the next two periods combined. What does this tell you? 

While profitability continued to improve, the rate of overall improvement has slowed. A switch to returns finds similar paths for ROA, ROIC, and ROE, with profitability jumping between the September 2012 and December 2012 periods, and then advancing at a steadier rate.

Taken on their own, rising margins and returns send a positive signal. For example, a high and rising ROE ratio suggests a healthy, fast-growing company becoming more efficient over time. But like every other financial ratio, ROE will sometimes lie to you. 

Suppose Acme Widget’s ROE has risen sharply over the last year. While this could simply reflect equity and profits rising even faster—the situation most investors desire—that’s not necessarily the case. If Acme lost money last year, and the loss reduced its equity, then the denominator of the ROE ratio would decline, and the ratio itself could rise even if Acme delivered no profit growth.

A similar scenario played out with Lockheed Martin, one of Honeywell’s competitors. During 2012, Lockheed’s pension liabilities jumped, knocking its equity value down to $39 million in December 2012 from $2.44 billion in September. 

That decline showed up in the average equity value. In the year ended December 2012, Lockheed’s ROE rose to 162.9% from the already high 153.9% in the year ended September 2012. The ROE has continued to rise as the average equity includes additional quarters with tiny equity balances. Lockheed’s equity has also somewhat artificially inflated its ROIC.

Has Honeywell fallen prey to a similar trend, with shrinking assets, shrinking invested capital, or shrinking equity skewing its returns? No, it has not. The table shows its assets trending higher, and a quick review of the company’s balance sheets would reveal invested capital and equity generally rising over the last two years.

Sometimes you’ll end up looking back at the financial statements to clarify a point or two. Good stock pickers understand that even the most carefully prepared statistics don’t always tell the whole story. In this case, you shouldn’t have to do any extra work. Honeywell didn’t fall prey to either of the two key danger signs:

• Extremely high or low margins relative to similar companies, or relative to its own profitability based on other statistics.
• Sharp swings in returns from quarter to quarter. If trailing 12- month ROE jumps to 20% from 10% just three or four quarters ago, you need to know why.

2) Compare short-term trends to long-term trends.

While Honeywell’s net profit margin fell in 2010 and 2011, it rebounded to 7.8% in 2012, a level similar to where it was in 2008. Similar patterns played out with operating and gross margins. ROA, ROI, and ROE all moved in a somewhat similar fashion. However, a lot of companies saw their profitability fall during the recession, so consider Honeywell’s short-term volatility a yellow light rather than a red light.

On their own, the long-term trends themselves tell us something about the company’s profitability over time. But combined with the more recent margins, we can draw a couple of inferences about Honeywell:

• In the most recent period, net margin and gross margin rose above levels seen during most of the last five years. ROA and ROIC also rose above levels seen over the last four years.
• The unusually high profitability—coupled with the slowdown in the expansion of profit margins and balance-sheet returns over the last two quarters—suggests the company may have trouble widening its margins and returns much further. By themselves, these numbers shouldn’t scare you away from Honeywell; plenty of companies bust out from historical ranges. Still, you can’t ignore the possibility that profitability is topping out.

3) Compare the profitability of the target company with its peers.

Honeywell’s ROA of 7.7% in the year ended June 2013 topped the 7.5% earned by the other three companies. With all four companies in the same ROA neighborhood, and with Honeywell not managing the top return in the two previous periods, it’s tough to label one as more profitable than the others. 

However, Honeywell’s ROIC and ROE exceed those of two of its competitors. Lockheed earns higher returns, but that company’s problem with unusually low equity suggests you should ignore those values.

Measurably more profitable than its peers in four of the six statistics (three types of margin and three types of return), Honeywell stands out from the crowd based on this comparison. The numbers reviewed in the three-step analysis process inspire a few conclusions about Honeywell:

• The company has improved its profitability substantially over the last year, suggesting greater operating efficiency.
• Honeywell already operates more profitably than its peers.
• Honeywell suffered sharper declines in profitability during the economic downturn than the other companies. Possible reasons include a more cyclical business mix or a breakdown in operating efficiency. Regardless of the reason, Honeywell has staged a recovery.
• With profitability already high, Honeywell will need to break out above historical levels to keep improving.

4. Putting It All Together

Now you know three different ways to assess a stock: valuation, growth, and profitability. No investor should make a buy or sell decision without reviewing a company from all three angles. And make no mistake, the three concepts you just learned are the beginning, not the end. If value intrigues you, go ahead and dive deeper into the topic. You’ll discover a host of valuation ratios and many ways to interpret them. 

The same goes for growth and profitability. You can spend as much or as little time as you want to work on your portfolio. Millions of individual investors have become experts simply by putting in the hours, some of which are spent reading books like this one. 

They’ve learned by experience and by doing their homework, just as you’re doing now. Until you’ve assembled the statistics and performed the calculations to determine growth rates or profit margins, you cannot truly understand what the rates and margins mean.

Finding New Stock Ideas

So far the research has focused on Pizer and Honeywell. For your next analysis project, pick whatever stock interests you. With thousands of stocks available, the task may sound daunting, but it doesn’t have to be. Consider these four strategies for inspiration:

• Focus on a stock recommended by someone you trust, particularly if you already know the company, and it looks good from several directions.
• Select a company you like, preferably one that uses a business model you understand. Investment guru Peter Lynch has long counseled to invest in what you know. And you know more than you think. If you work in a steel mill or manufacturing plant, you may already possess the expertise needed to pinpoint which portions of the industrial sector have—and will most likely continue to have—traction. Doctors possess insight into health care, while store managers have a good handle on consumer behavior. Your existing base of knowledge already provides you with a leg up on other individuals who haven’t shared your experiences.
• Target an industry, not a company. Suppose you’re bullish on hotels, but don’t have a favorite. Pick 10 stocks and perform a valuation analysis. That first round of analysis should knock a few off the list. With each round, you can narrow the field further.
• Let your preferred approach lead you. If the concept of growth analysis resonates with you, read stories in the newspaper and on the Internet that focus on growth stocks. In reading interviews with growth investors or stories about growth strategies, you’ll encounter lists of stocks that might interest you. Stay away from the tiny, risky, low-profile stocks that few analysts follow, at least until you’ve amassed more experience.

Maintaining Balance

Whatever method you use to select stocks and whichever form of analysis you like best, don’t abandon a balanced approach. Start with your favorite, then move on to the others. Each of the analysis techniques presented earlier shines a light on a stock from a different angle, and while all of the approaches provide tangible reasons to either buy a stock or leave it be, the interplay between the strategies provides the broadest perspective and the fullest picture.

For example, an analysis of Pizer provided a few valuable insights about the appeal of the stock relative to its rivals, but that doesn’t mean the mission failed. When you analyze a stock, you seek not only reasons to buy it, but also reasons to avoid it. 

Sometimes the numbers lead to obvious conclusions—Pizer doesn’t offer much growth potential. At other times, the data does little to differentiate a company from its peers—Pizer’s valuation ratios don’t stand out. Growth-oriented investors might prefer one of the other drug stocks to Pizer. 

However, compared to other groups, the large-cap drugmakers as a whole offer subpar growth and probably won’t appeal to investors focusing on companies able to significantly increase sales and profits. While value investors might not dismiss Pizer out of hand, the company certainly doesn’t distinguish itself based on its valuation.

Just as important as the trends themselves is the interplay among the different characteristics. For example, while profitability analysis did help Honeywell differentiate itself from others in the defense group, current profit margins and balance sheet returns inspire questions about whether the company can continue improving its efficiency. As you move toward any buy or ignore the decision, remember the following points:

• In a vacuum, you should favor a cheap stock over an expensive one. However, you should also be aware that stocks often decline in price and command low valuations because of glaring weaknesses in other areas.
• You want to see strong growth in sales, profits, and operating cash flow, but some companies overextend themselves financially to raise cash to fund expansion. A look at profitability trends can help you spot these troublemakers.
• Hosts of stocks offer either high growth or cheap valuations, but few look good from both angles. If you insist on both growth and value, you will limit your pool of investments. However, the stocks that satisfy your criteria are far more likely to leap off the page.
• Improving profitability is generally a good sign, but when companies take it too far, they can cripple their growth potential. Sometimes increases in profit margins and returns on assets, invested capital, or equity reflect genuine profit expansion, but not all the time. By combining profitability and growth analysis, you can identify companies not only increasing their profits but also growing them efficiently.
• View extremes with caution. Sure, you want cheap stocks or fast growers. But if your stock trades at 10 times earnings while its peers trade at 20 times, don’t rush in. Markets often drive stocks to rock-bottom valuations in response to increased risk. If analysts expect your stock to increase its profits at a 20% annual rate while other stocks in its industry grow only half as fast, expect higher-than-average valuation ratios—and make sure you assess profitability to see whether the company is growing wisely.

Pulling the Trigger

No two stocks are the same, and every time you analyze a stock, you’ll find something different. Pulling the numbers from financial statements to review Coca-Cola, IBM, or Exxon Mobil would have revealed different strengths and weaknesses than those of Pizer and Honeywell. And if you wait two or three quarters and revisit Pizer, the numbers might tell a different story than they did in this analysis.

Pizer’s very lack of exceptional characteristics proves the value of the analysis. Many stocks—in fact, most of them—won’t separate themselves from the pack if you look beyond the obvious. As an investor hoping to build wealth by purchasing stocks that will rise— hopefully, more than the broad market—you don’t want these stocks. A lot of companies excel in one or two areas, but few distinguish themselves with broad-based excellence. You want to find those few because only the truly exceptional stocks are worth your effort.

Now, don’t misread this. If you hold off until you find the perfect stock, you’ll spend the rest of your life sitting on your money. Every company has a weakness, and most have several. But that’s why you perform the analysis. Find the weaknesses and identify the strengths. When you uncover a stock strong in multiple areas with only a couple of minor flaws, you may have a winner. Then again, you may not. That’s just how it goes in the stock-picking business.

Sometimes, no matter how much effort you invest in a stock, that stock will still break your heart. But if you own 25 stocks, you can handle a little heartbreak. It only takes a couple of big gainers to offset a few losers. And if you own 25 high-quality stocks that have satisfied your exhaustive research criteria, you’ve probably found a few of those big gainers.

5. Getting The News

By now, you’ve isolated a few companies with attractive valuations, solid growth, and strong profitability trends. That kind of fundamental stock analysis can eliminate most of the bad apples. Still, before you buy, set the numbers aside and focus more on the words. 

Specifically, learn about the company behind the ticker symbol in nonmonetary terms. Plenty of companies look good by the numbers, but statistics rarely tell the whole story.

This section provides 10 steps to transition you from a careful stock analyst to a wise stock owner. The first five provide tips for making informed stock purchases, while the second five illustrate some ways to keep your portfolio fresh and vibrant after you buy.

Company Analysis: Beyond the Numbers

1) Keep up with news about your stocks. Following the financial news can seem daunting. Thousands of stories compete for your attention each day. You can safely ignore most of them, but if you own 25 stocks, take the time to read the company releases about financial news or new products. Many portfolio trackers allow you to view headlines related to the ticker symbols on your list. See what analysts and journalists have to say, including their views about competing companies. If Acme’s biggest rival has just introduced a new widget that renders your company’s key product obsolete, you should know about it.

2) Subscribe to the Wall Street Journal. If you hope to keep up with the financial markets, no other news source will help you more. The Journal has valueless as a source of company news than as a gateway to the broad market and the forces that drive it. Plus, the paper offers well-written stories on a variety of topics.

3) Actually read the Wall Street Journal. Of course, this sounds obvious. But no newspaper has ever spent more time on desks or in briefcases without being used than the Wall Street Journal. Plenty of people carry the Journal around—often for the same reason, some people keep works like The Critique of Pure Reason or Anna Karenina in a prominent place on a living room shelf, despite never having read the books.

4) Believe half of what you read and less of what you hear. If you want to read Internet columnists or watch CNBC, go ahead. They can provide valuable insight. However, you should also realize that many of these commentators have agendas of their own. While most media outlets at least attempt to remain unbiased, some do the job better than others, and the pundits they interview have no compunction for pushing an agenda.

5) Never, ever, ever, ever act on a stock tip. At least not without doing your own research. With more than 5,000 stocks on the market, you can’t own all the good ones. Just because someone with a loud voice and a million Twitter followers insists that you buy Acme Widget before it triples doesn’t mean the stock makes sense for you—or that it will triple.

Following Through: Keeping Up with Your Stocks

Consider politics for a moment. During an election year, you research candidates, assessing their positions and qualifications. In the end, you select the one you believe will best represent your interests. And then, if you operate like most people, you leave the ballot box and don’t think much about your choice until the next election comes around. Four years later, if the guy you elected did a good job, you vote for him again.

If he messed everything up, you get the chance to replace him with someone who can do better. Sounds a lot like a stock portfolio.

But stocks offer at least one advantage over politicians. If your stocks tank, you can get rid of them without going through the trouble of justifying and then actually achieving an impeachment. Just sell them and find replacements. 

No majority opinion is needed. Unfortunately, as with politics, too many investors don’t follow through on or keep up with their investments. Buying the stock doesn’t end the process, because investing is less of a job and more of a journey. You purchase a stock, you monitor the stock, and you sell the stock when it no longer makes sense to own it. Along the way, you’ll buy and sell other stocks. Each purchase and sale is a destination along the way.

Conscientious investors—the kind who actually take steps to achieve their financial goals rather than simply dream about them— never really take off their investing hats. Managing your portfolio need not be a full-time job. In fact, it shouldn’t take nearly that much time. For most people, spending more than 10 hours a week working on investments reflects poor time management. Of course, spending less than an hour a week reflects foolishness, at least for anyone who wishes to do her own research. 

Following your stocks generally takes less time—and less math—than analyzing them. The following five steps should give you all you need to keep up with your investments— without turning the task into a second job.

6) Track your portfolio. The Yahoo!, MSN, and Google finance websites all offer portfolio trackers, as do a host of other sites, including many brokerages. Use one of these services to create a portfolio that includes all your stocks, mutual funds, and exchange-traded funds, and visit it at least once a week. If you’re prone to panic whenever you see the red of a price decline on the screen, don’t visit more often than a couple of times a week. Stock prices change, and even the best ones don’t rise every day. Your portfolio will see good days and bad. The better you manage it, the higher the percentage of good days.

7) Investigate problems. Say you check your portfolio for the irst time in a week and see that Acme Widget has declined 5% since the last time you looked at it. If most of your stocks and the broader market have posted similar declines, Acme probably warrants no extra attention. On the other hand, if Acme has fallen despite steady or rising prices for most of the market, you must find out why.

8) Reassess your stocks frequently. You don’t need to repeat your statistical analysis every week. Even if a company doesn’t generate much news regularly, be sure you think about it from time to time. If shares rise or fall more than 10% from the point when you bought them, you might want to repeat your valuation analysis.

9) Revisit the financials once a quarter. Every quarter, companies release the next phase of their growth and profitability metrics. Once your company has updated all its numbers, see if those profitability and growth trends have changed. You may have to wait a while if the company doesn’t give you everything in the earnings release. In that case, turn to the SEC filings. This shouldn’t take long, as you’re just adding the most recent quarter to historical data you’ve already collected.

10) Don’t overreact to the news. This may be the hardest advice to follow, and it deserves some extra space. Sometimes your company posts bad quarterly results, and the shares take a dive. Sometimes government regulators enact new rules that will cost your company money. And sometimes the stock simply declines because of weakness in its industry or sector. In all three cases, knee-jerk reactions can cause you to make mistakes.

Stocks often rally the day after bad news sparks a sell-off, and selling immediately on bad news can cost you money. Of course, some stocks do keep going down. For the most part, investors shouldn’t try to diagnose long-term effects based on initial media reports—at least not enough to warrant a quick sell decision. 

Plenty of companies sees their stocks dip 10% (or even 20%), only to bounce back to new highs in a few weeks or months. Determining whether or not a troubled stock will accomplish this feat may be the toughest task an investor’s faces. Of course, there is no single formula for doing it right, because no two situations are alike.

When deciding how to react in the wake of bad news, consider the following points:

Put more weight on news that affects a company’s operations. If a rival comes out with a new product that threatens to take market share, look into it. Has your company historically responded well to such crises, coming out with its own new products? What do analysts who follow the stock say about its ability to compete? If you believe a development will substantially slow sales or profit growth, it might be time to sell.

Don’t get worked up over legal battles. The raft of tobacco lawsuits in the early 2000s changed the way the industry did business, as did the regulatory crackdown on banks after the fiscal crisis of 2008 and 2009. The vast majority of consumer lawsuits and antitrust actions don’t have that effect. Additionally, remember those special items companies exclude from their earnings? Legal judgments and settlements generally end up in that category. While headlines can hurt the stock in the near term, the long-term picture probably hasn’t changed much.

The crowd isn’t always right, but most of the time, when the crowd zigs, zagging will get you into trouble. The easiest way to make a fortune is to take a stand and make a big bet when the entire market has a bet on the other side. Unfortunately, such strategies can cause investors to lose fortunes even more easily.

If everyone sells on the first day, you can equate it to sheep running from danger. The same goes for the second day. 

But if the share price continues to degrade and the news remains bad, ignore the headlines at your peril. By all means, stick with a stock if you see the reason for optimism and if you believe the company can fix whatever problem caused the shares to fall. However, if you lack such conviction, don’t fear to sell, even if you end up getting it wrong. 

There’s no shame in backing out of what looks like a bad investment and switching to something with more potential. You won’t always act at the proper time, and sometimes you’ll sell when you should have bought. It happens. But what’s the best remedy for missing out on a rally in a stock you sold too soon? The rally you enjoy from the stock you just purchased.