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Michael C. Thomsett is a widely published options author. His "Getting Started in Options" (Wiley, 9th edition) has sold over 300,000 copies. He also is author of "Options Trading for the Conservative Investor" and "The Options Trading Body of Knowledge" (both FT Press); and "Options for... More
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Michael C. Thomsett, author
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Getting Started in Stock Investing and Trading
  • 3 Key Fundamentals For Picking Stocks 0 comments
    Mar 15, 2014 12:54 PM

    Fundamental analysts can find value in dozens of ratios and trend. However, three very valuable indicators, when used together, provide a very reliable method for narrowing down the list of candidates. These are debt ratio, P/E ratio, and dividend yield.

    1. Debt ratio.

    The debt ratio is easily overlooked because in focused on long-term debt. For tests of working capital, it is easier and more immediate to focus on current ratio as a primary evaluation of cash management. But this is a mistake, for a couple of reasons.

    First of all, by taking on higher long-term debt and keeping the proceeds in cash, the current ratio can be artificially kept at "normal" levels, even while net losses take place. There is nothing illegal about this practice, even though it deceives fundamental analysts.

    More important, if a company's debt ratio is high or moving higher, it means future profits will be going increasingly to debt service, with less remaining for dividend payments or funding of expansion. In severe cases, high debt ratio signals a move toward insolvency. If the ratio is above 100, it means that debt has wiped out all of the equity. Liquidation value at this point is below zero.

    2. P/E ratio.

    The P/E multiple is a representation of price. A high P/E means the stock is too expensive, and an exceptionally low P/E means there is little interest in the company's growth potential. Most investors agree that a multiple between 10 and 25 is a healthy mid-range for P/E.

    In evaluating P/E, don't rely only on today's multiple. Check several years' P/E range from high to low, and look for consistency. This is a trouble ratio because the time periods are not the same. Price is a technical indicator today, but earnings per share may be several months out of date. This is why the range and trend are the important tests.

    3. Dividend yield.

    Among the most overlooked aspects of stock selection is the dividend yield. As prices fall, yield rises because it is based on current price (which changers) versus dividend per share (declared annually). But dividend yield may represent a major portion of overall portfolio returns, and that should not be ignored.

    One way to identify exceptional value investments is to narrow the search down to dividend achievers, defined as companies whose dividend has increased every year for at least 10 years. When a company is able to meet this test, it signals profitability and cash flow management. A majority of dividend achievers also tend to perform at the top and to grow at a better than average rate.

    These three tests may not work as a complete or total fundamental testing system. But as a starting point, if you narrow down your list of candidates to those excelling in all three of these areas, it makes the task of picking your next stock much easier, and much more reliable.

    To gain more perspective on insights to investing observations and specific analysis, I hope you will join me at ThomsettStocks.com where I publish many additional articles. I also maintain a virtual portfolio of stock at ThomsettStocks.com. For new trades, I usually include a stock chart marked up with reversal and confirmation, and provide detailed explanations of my rationale. Link to the site to learn more.

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