Identifying potential stock investments

What do you need to know to determine which stocks are potential investments? To get started, stick with stocks relating to your own interests or knowledge. If you frequent particular stores or restaurants and you use and like their products, find out if they are publicly held companies. Start identifying and watching these stocks. That advice doesn’t mean that you should buy their stock right away. You still have some homework to do.
The following list tells you what to look for when investigating potential stock investments. S&P’s Personal Wealth newsletter, which is available at most libraries (and online at www.personalwealth.com), along with the ValueLine newsletter (www.valueline.com) and any brokerage firm analyst report can provide you with much or all of the following pertinent facts and measures

• Find out if the industry is growing. Some industries aren’t. News stories on the industry in question can tell you the state of the industry and so can the company’s annual report. Company shareholder departments and the Securities and Exchange Commission (SEC), the Washington, D.C.-based regulator that oversees public companies, can provide you with copies of annual reports and the quarterly reports (called 10Qs) that companies must file. You can also find them on the Internet at www.freeedgar.com.
• Find primary competitors. Don’t look at a stock in isolation. A company that looks enticing by itself may look like a 100-pound weakling when you evaluate its strengths and weaknesses next to the leading competitors in the industry. Check out at least two competitors of any stock you’re evaluating.

• Check out annual earnings and sales. This is key in deciphering how quickly a company is growing over oneyear, three-year, and five-year time periods, and whether its earnings are keeping pace with sales. Look for growth rates of at least 10%.
• Look at the stock’s price-to-earnings (P/E) ratios. This is the primary means of evaluating a stock. The P/E ratio is derived by dividing a stock’s share price by its earningsper-share. The result tells you how much investors are willing to pay for each $1 of earnings. Those stocks that have faster earnings growth rates also tend to carry higher P/Es, which means that investors are willing to pay through the nose to own shares. The value of a P/E ratio, however, can be subjective. One investor may think that a particular company’s P/E ratio of 20 is high, while another may consider it low to moderate.
• Find out the price-to-book value (P/B) ratio. The P/B ratio is the stock’s share price divided by book value, or a firm’s assets minus its liabilities. This ratio is a good comparison tool and can tell you which companies are assetrich and which are carrying more debt. A low P/B ratio can be an indicator that a stock may be a good value investment.
• Check out the stock’s price-to-growth flow ratio. This ratio is the share price divided by growth flow (annual earnings plus research-and-development costs) per share. This is a useful measure for assessing fast-moving companies, especially in the technology sector, where management often puts profits back into product development.
• Look at the stock’s PEG ratio. The PEG ratio is a company’s P/E ratio divided by its expected earnings’ growth rate and is an indicator of well-priced stock. In a soaring stock market, like the one that dominated the 1990s, a PEG ratio below 1.5 suggests that a stock may be a good value. A PEG ratio above 2 can indicate that a stock may be overheated.
• Look ahead. Projections of five-year annual growth rates and five-year P/E ratios can tell you whether analysts believe that the companies you’re evaluating can continue to grow at their current rate, can beat it, or will start to fall behind. Make a list of the stocks you are interested in and watch their performance over time. Doing so gives you a feel for how the stocks respond to different types of economic and market news. You can also see which stocks’ prices move around and are more volatile.

So does your own analysis indicate that you have a winner on your hands or a dog? If you’re unsure, sit tight and watch what happens in the weeks and months ahead. Watching several stocks over a period of time not only tells you how well they’re doing, or not doing, it can also show you how well you’re honing your own stock analysis skills.