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 Home Depot (NYS: HD) 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 Home Depot.
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%
3 out of 10
Source: S&P Capital IQ. Total score = number of passes.
Since we looked at Home Depot last year, the company has lost a couple points. Falling dividend growth and a much higher valuation are to blame for the home improvement retailer's drop in score, although it came with a nearly 50% gain for shareholders.
You'd think that a dicey housing market would have left Home Depot with some big challenges. Rival Lowe's (NYS: LOW) has struggled with weak sales for years, and other smaller niche home-product retailers have had even larger troughs in demand. Conditions have been even worse for homebuilders Pulte (NYS: PHM) , Hovnanian (NYS: HOV) , and Beazer Homes (NYS: BZH) , all of which have seen only minimal rebounds from the huge revenue destruction that's happened since the end of the housing boom. Yet Home Depot has been able to survive and even thrive in the bust, with shares recently hitting near decade highs.
A big part of Home Depot's success has been its ability to capitalize on the remodeling trend while at the same time doing its best to cut costs. But a company can only rely on factors like that for so long, as Home Depot's most recent results show. Even after the warm winter, Home Depot wasn't able to meet revenue estimates for its first quarter.
For Home Depot to improve, a lot will depend on how housing performs in the very near future. If the slow recovery trend continues, then the stock could keep doing well. But if the economy tips back toward stagnation or contraction, then all the hopes Home Depot shareholders have could evaporate quickly.
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 contributor Dan Caplinger doesn't own shares of the companies mentioned in this article. Motley Fool newsletter services have recommended buying shares of Home Depot and writing covered calls on Lowe's. 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 a disclosure policy.
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