Courtesy : Investopedia
Many investors are
confused when it comes to the stock market — they have trouble figuring
out which
stocks are good long-term buys and which ones
aren't. To invest for the long term, not only do you have to look at certain
indicators, you also have to remain focused on your long-term goals, be
disciplined and understand your overall investment objectives.
Focus on the
Fundamentals
There are many
fundamental factors that analysts inspect to decide which stocks
are good long-term buys and which are not. These factors tell you whether the
company is financially healthy and whether the stock has been brought down to
levels below its actual value, thus making it a good buy.
The following are
several strategies that you can use to determine a stock's value.
Dividend
Consistency
The consistency of a
company's ability to pay and raise its dividend shows that
it has predictability in its earnings. It also shows that it's financially
stable enough to pay that dividend (from current or retained
earnings). You'll find many different opinions on how
many years you should go back to look for this consistency — some say
five years, others say as many as 20 — but anywhere in this range will
give you an overall idea of the dividend consistency.
Examine the P/E
Ratio
The price-earnings ratio (P/E) ratio is used to determine whether a stock is over or
undervalued. It's calculated by dividing the current price of the stock by the
company's earnings per
share. The higher the P/E ratio, the more
willing some investors are to pay for those earnings. However, a higher P/E ratio
is also seen as a sign that the stock is overpriced and could be due for a
pullback — at the very least. A lower P/E ratio could indicate that the
stock is an attractive value and that the markets have pushed shares below
their actual value.
A practical way to
determine whether a company is cheap relative to its industry or the markets is
to compare
its P/E ratio with the overall industry or
market. For example, if the company has a P/E ratio of nine while the industry
has a P/E ratio of 14, this would indicate that the stock has an
attractive valuation compared with
the overall industry. But on the other hand one should also check whether there
is any specific reason for such high P/E ratio like possibility of robust
business growth in future..etc
Watch for
Fluctuating Earnings
The economy moves in
cycles. Sometimes the economy is strong and earnings rise. Other times, the
economy is slowing and earnings fall. One way to determine whether a stock is a
good long-term buy is to evaluate its past earnings and future earnings projections.
If the company has a consistent history of rising earnings over a period of
many years, it could be a good long-term buy.
Also, look at what
the company's earnings projections are going forward. If they're projected to
remain strong, this could be a sign that the company may be a good long-term
buy. Alternatively, if the company is cutting future earnings guidance, this could be a sign of earnings weakness and you might
want to stay away.
Avoid Valuation
Traps
How do you know if a
stock is a good long-term buy and not a valuation trap (the
stock looks cheap but can head a lot lower)? To answer this question, you need
to apply some common-sense principles, such as looking at the company's debt
ratio and current ratio.
Debt can work in two
ways:
- During times of economic
uncertainty or rising interest rates, companies with high levels
of debt can experience financial problems.
- In good economic times, debt
can increase a company's profitability by financing growth at a lower
cost.
The debt ratio
measures the amount of assets that have been financed with debt. Generally, the
higher the debt, the greater the possibility that the company could be a valuation
trap.
There is another tool
you can use to determine the company's ability to meet these debt
obligations — the current ratio. To calculate this number, you divide
the company's current
assets by its current
liabilities. The higher the number, the
more liquid the company is. For example, let's say a company has a current
ratio of four. This means that the company is liquid enough to pay four times its liabilities.
By using these two
ratios — the debt ratio and the current ratio — you can get a good
idea as to whether the stock is a good value at its current price.
Analyze Economic
Indicators
There are two ways
that you can use economic indicators to understand what's happening with the
markets.
Understanding
Economic Conditions
The major stock
market averages are considered to be forward-looking economic indicators. For
example, consistent weakness in the Dow Jones Industrial Average could signify that the economy has started to top out and
that earnings are starting to fall. The same thing applies if the major market
averages start to rise consistently but the economic numbers are showing
that the economy is still weak. As a general rule, stock prices tend to lead
the actual economy in the range of six to 12 months.
Evaluate the
Economic "Big Picture"
A good way to gauge
how long-term buys relates to the economy is to use the news headlines as
an economic
indicator. Basically, you're using contrarian indicators from the news media to understand whether
the markets are becoming overbought or oversold.
The Bottom Line
Investing for the long term requires
patience and discipline. You may spot good long-term investments when the company or the markets haven't been performing so well.
By using fundamental tools and economic indicators, you can find those hidden
diamonds in the rough and avoid the potential valuation traps.
