What Makes a Perfect Stock?

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Over the past several years, I've looked at hundreds of different companies in a quest to find stocks with the ideal combination of favorable attributes.

Yet while few stocks have everything one might want to see in an investment, knowing the most desirable traits of great stocks can guide you in making choices for your own portfolio.

Here's a guide to what to look for in a stock to decide whether it's perfect for you.

Growth: The Key to Future Value

Stagnant businesses without any future prospects may be profitable, but they can't produce the strong returns that stock investors rely on. Therefore, for a business to thrive, it needs to grow.

Healthy businesses focus on increasing the sales they make to their customers year in and year out, finding new ways to capture more revenue from their existing clientele, and offering innovative high-value goods and services to bring new customers in the door.

The best growth stocks are able to grow sales at a 15 percent annual clip consistently over a long period of time. Although year-to-year blips may temporarily depress growth, keeping sales up over the long haul ensures that companies remain on the cutting edge of their industries and aren't simply coasting on their past success.

Profitability: Turning Sales Into Cash

As important as sales growth is, a company won't survive if its costs are greater than what it gets paid for its products. Businesses need to control their costs and allow as much of their sales to fall through to the bottom line as net income.

To measure exactly how much of every dollar of revenue becomes profit, you can look at various margin figures.

  • Gross margins tell you what percentage of sales revenue is left after subtracting the direct costs of producing goods or providing services.

  • Net margins deduct the other expenses of doing business, such as overhead, marketing and advertising, and interest expense.

Gross margins above 35 percent and net margins of 15 percent or more indicate that a company is working hard to squeeze as much profit as possible from its business.

In some industries, though, these numbers aren't realistic. For instance, in the grocery business, much narrower margins exist because the goods are commodities, with prices subject to market forces rather than being under the grocer's control. But when you compare a stock to its industry peers, high margins indicate a superior company.

Another measure of profitability is return on equity, which measures how much profit a company produces in comparison to the shareholder equity within the company. Returns on equity of 15 percent or more indicate that a company is finding lucrative opportunities to invest in its business that create substantial profits. In contrast, lower or negative returns on equity suggest that companies might be better off simply returning shareholder capital to investors in the form of dividends.

Balance Sheet: Being Responsible With Shareholder Value

As a stock investor, you benefit the most from increases in a company's overall value. But if the company has other stakeholders -- such as bondholders or banks that lend it money -- then it can't focus solely on doing whatever it takes to make your shares worth as much as possible.

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In certain cases, companies have to take actions that harm their shareholders in order to fulfill their obligations to their creditors.

To avoid those conflicts, the best stocks keep control of their debt. It's not necessary to avoid debt entirely, but keeping it down to manageable levels of less than 50 percent of shareholder equity will help ensure that debt doesn't create difficult situations for stock investors.

Valuation: The Right Stock at the Right Price

A great company can be a terrible investment if you have to overpay for it. Countless companies have had amazing growth prospects only to collapse under the weight of their own business models, and investors who get caught up in stock-market hype rather than business fundamentals often end up overpaying for hot stocks.

Different investors have different thresholds for valuations based on earnings, but looking for a price-to-earnings ratio of 20 or less is a very reasonable benchmark. The best value stocks often sport earnings multiples well below 20, but using a somewhat higher standard leaves room for higher-growth companies that command more respect from investors.

Dividends: How a Stock Rewards You

Finally, the best stocks not only pay solid dividends but continue to reward shareholders through dividend increases over time. In the end, the cash you get in dividends is the most tangible sign of a stock being a good investment.

Looking for stocks with dividend yields at or above the 2 percent level corresponds well to the average dividend for the broader market. Seeking a record of 10 percent annual dividend growth weeds out stagnant stocks with poor growth prospects.

Don't Settle For Less Than the Best

Finding stocks that have all of these traits is a tall order. But if you can identify which stocks excel at delivering these desirable attributes to their shareholders, it can give you a useful starting point in deciding whether a stock belongs in your portfolio.