It definitely pays to thoroughly investigate new stock additions to your portfolio. But does every stock warrant the same intense and time-consuming evaluation? No, and here's how to separate the handful of wheat from bushels of chaff in 10 minutes or so. You'll find all the information you need to answer these first-cut questions in Morningstar Library Edition's 10 years worth of data on stocks.
- Does the stock pass a minimum quality hurdle?
Companies with tiny market capitalizations that trade on the bulletin boards (also known as pink sheets), foreign firms that don't file regular financials with the SEC, and IPOs--you'll sleep better by avoiding them all. - Has the company ever made an operating profit?
Oddly, companies that have never and/or have no immediate prospects of turning a profit often generate lots of excitement. Think cure for a rare disease. Best to stay away. - Does the company generate consistent cash flow from operations?
Reject any company with negative cash flow from operations. Eventually, they will have to seek additional financing by selling bonds or issuing more shares. The former increases risk and the latter dilutes shareholder ownership. - Are returns on equity consistently above 10%, with reasonable leverage?
Generally speaking, if the answer is no, say no to the stock. Leverage (basically debt) should be in line with the industry's norms. - Is earnings growth consistent or erratic?
It's best to go with the consistent bunch. Erratic earnings growth might mean a company is in a volatile business or, worse, competitors are pummeling it. - How clean is the balance sheet?
In most cases, you'll be doing yourself a favor by avoiding nonbank companies with financial leverage ratios above 4 or a debt/equity ratio over 1. - Does the firm generate free cash flow?
If not, it's usually best to bypass it. The exception, however, is a company that is reinvesting its cash in its business wisely. If you aren't sure about the wise part, research what the experts are saying, or avoid the stock. - How much "other" is there?
Management can hide bad decisions in supposedly one-time charges. If a company is questionable on other fronts and also has many "others," steer clear. - Has the number of shares outstanding increased markedly over the past several years?
This could mean the company is using shares to buy companies or reward employees. The former is a red flag because most acquisitions fail. The latter isn't good because it means your ownership stake is shrinking. If outstanding shares consistently increase year to year by 2% or more, think long and hard about investing.
Morningstar.com is great tool for new and veteran investors. It's chock full of unbiased analyst reports, tools for evaluating your portfolio, and lessons on how to invest. The best part is that it's free to all valid library cardholders! Begin now or learn more.
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