Every investor would love to stumble upon the perfect stock. But will you ever really find a stock that provides everything you could possibly want?
One thing's for sure: You'll never discover truly great investments unless you actively look for them. Let's discuss the ideal qualities of a perfect stock, then decide if Toll Brothers (NYS: TOL) fits the bill.
The quest for perfection
Stocks that look great based on one factor may prove horrible elsewhere, making due diligence a crucial part of your investing research. The best stocks excel in many different areas, including these important factors:
Growth. Expanding businesses show healthy revenue growth. While past growth is no guarantee that revenue will keep rising, it's certainly a better sign than a stagnant top line.
Margins. Higher sales mean nothing if a company can't produce profits from them. Strong margins ensure that company can turn revenue into profit.
Balance sheet. At debt-laden companies, banks and bondholders compete with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
Money-making opportunities. Return on equity helps measure how well a company is finding opportunities to turn its resources into profitable business endeavors.
Valuation. You can't afford to pay too much for even the best companies. By using normalized figures, you can see how a stock's simple earnings multiple fits into a longer-term context.
Dividends. For tangible proof of profits, a check to shareholders every three months can't be beat. Companies with solid dividends and strong commitments to increasing payouts treat shareholders well.
With those factors in mind, let's take a closer look at Toll Brothers.
What We Want to See
Pass or Fail?
5-Year Annual Revenue Growth > 15%
1-Year Revenue Growth > 12%
Gross Margin > 35%
Net Margin > 15%
Debt to Equity < 50%
Current Ratio > 1.3
Return on Equity > 15%
Normalized P/E < 20
Current Yield > 2%
5-Year Dividend Growth > 10%
1 out of 9
Source: Capital IQ, a division of Standard & Poor's. NM = not meaningful due to negative earnings. Total score = number of passes.
With just a single point, Toll Brothers is about as far from perfection as you can get. The homebuilder has faced the worst period for housing in history, and at least for now, there's no clear end to the pain in sight.
The terrible housing market has taken a bite out of the entire homebuilding industry. For years, homebuilders have faced falling revenue, big losses, and a lack of any obvious turnaround. Housing expert Robert Shiller thinks that even after steep drops, housing prices could fall 10% to 25% more.
Toll Brothers hasn't lost hope, though. In Toll's most recent quarter, pre-tax income jumped even excluding a lucrative tax benefit that accounted for most of the company's net profits. But revenue dropped 13%, with the company delivering 14% fewer homes and seeing higher cancellation rates than a year ago. Backlogs also jumped -- a positive sign compared with drops at Lennar (NYS: LEN) and KB Home (NYS: KBH) .
With better returns on equity and far less leverage than PulteGroup (NYS: PHM) and Beazer Homes (NYS: BZH) , Toll Brothers seems best poised to rebound when the housing market recovers. The big question, though, is when that recovery will start. Until it does, Toll Brothers isn't going to look like a perfect stock.
No stock is a sure thing, but some stocks are a lot closer to perfect than others. By looking for the perfect stock, you'll go a long way toward improving your investing prowess and learning how to separate out the best investments from the rest.
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At the time thisarticle was published Fool contributorDan Caplingerdoesn't own shares of the companies mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool has adisclosure policy.
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