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What is a fundamentally sound stock? What stocks are best to invest in

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  • What is a fundamentally sound stock? What stocks are best to invest in

    Basically, a fundamentally sound stock is a company that you would be willing to buy in its entirety if you had the ability to do so. Why buy a piece of company that you would not be willing to buy completely (unless of course you do not believe in the company entirely, in which case, why invest in it at all?) What kind of companies would a person be willing to buy? Well naturally, companies that are MAKING MONEY such that the investment of the company's purchase price would result in a nice RETURN ON THE INVESTMENT.

    Now, when I invest in a stock, and by invest I mean buy it for the future - to hold for years - I look for a company that I would not mind owning and would pay for to buy the entire company if I could, even at the price of whatever the company's value is based on its stock price and number of shares outstanding (its market capitalization).

    Of course I consider WHAT the company is doing, what sector it is in, what advantages the company has over its competition, who is in charge of the company, all of that - but then, those are analyses I would make ANYWAY when deciding whether to buy a company outright.

    But the first analysis hard nosed, numbers only analysis I make of a public company is to consider its EPS or earnings per share. For me, if a company has a negative EPS, meaning that the company is losing money, I am hard pressed to purchase its stock for investing, unless I am very convinced that it WILL make money in the future. A company that cannot turn a profit is nothing but a headache and a drain on its stockholders, who are basically funding a losing project. Any company that remains unprofitable WILL fail, and its stock WILL go down in the long term. Period, end of story, no exceptions. Look far enough on down the feeding trough, and you will find that this has always been true. After all, how may a company even keep going, and not go broke, if it keeps losing money?

    At the same time, companies with not only positive EPS, but GOOD EPS and RISING EPS, have always flourished as long as their EPS continues to rise, and the stock of such companies has always gone up.

    The SECOND factor to examine with a stock, is is P/E - price to earnings ratio. The EPS, considered in a vacuum, is meaningless unless compared with the price of the stock. After all, one company with an EPS of one dollar, selling at five dollars per share, is a relative bargain compared to a stock with a one dollar EPS trading at $200. per share. In order to evaluate P/E, you must look at the relative P/Es of other companies in that industry.

    For example, compare the current P/E of AAPL, 16.88, with that of IBM, 13.48 and MSFT, 16.25 This tells me that AAPL's P/E is right in the ballpark (the ballpark being, that of its peers), not too high, though not, unfortunately, too low, but good.

    These two factors are the most important to consider when investing in a stock, positive EPS and P/E. (In fact, a negative EPS means NO P/E at all, which is definitely not good.)

    In short, unless you really think you are getting in on the ground floor of some great company of the future that will make a gang of money, stick to blue chips, meaning stocks with high EPS and low P/E - industry leaders.

    Beyond these two all important factors, we also need to look at the BALANCE SHEETS of the companies, which are something ANYONE deciding whether to buy an entire company would examine.

    Cash flow?
    Cash on hand?
    Accounts Payable?

    ALL of the factors that an accountant would look at in deciding whether a company is healthy, so you should too - to decide whether a company is owed too much money compared to its inventory, has too little cash on hand compared to it income, etc. Even if you are not an expert in accounting, you may still determine enough from a balance sheet to decide where the company is today - which will give you a good snapshot into where it may be tomorrow.

    What I look for in balance sheets are:
    1. Increasing CASH over the years, which shows increasing strength.
    2. Ratio of CASH to receivables+inventory greater than 1.0
    A massive amount of receivables or inventory as compared to cash often flags a company as one in a position to lose money if its receivables accounts are delinquent. Stockpiling of inventory sometimes indicates weakening sales.
    3. Increasing NET INCOME over the years
    I like to see increased profitability in a company over time, and I do not like to see a flip flop of income, such as a company for example making $10M in Year One, then $5M Year Two then $11M Year 3
    4. Increasing NET SALES over the years.
    5. Ratio of net sales to cost of goods increasing over the years.
    This indicates that the cost of goods in the company is decreasing as volume of sales increases.

    Missing any one of these factors constitutes a flag, but does not necessarily mean that the company flunks my fundamental analysis screen.

    There are other factors I use - such as company research which includes analyst recommendations, forward P/E, earnings and estimates, and PEG (Price/Earnings To Growth) ratio, but for all of these, and elaboration on the above, you'll have to read my more intensive and much lengthier book on stocks and trading. But this post, is the basics.
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