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Determining The Stock Option Values

DIVIDEND REINVESTMENT PLANS

Municipal Bond Funds

How to find information about mutual funds

Types of Taxable Bond Funds

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Advantages and Disadvantages in the Granting of Stock Options

Setting your sights on your financial goals

A stock is considered a growth stock when it’s growing faster and higher than the overall stock market. Basically, a growth stock performs better than its peers in categories such as sales and earnings. Value stocks are stocks that are priced lower than the value of the company and its assets — you can identify a value stock by analyzing the company’s fundamentals and looking at key financial ratios, such as the price-to-earnings ratio. Growth stocks tend to have better prospects for growth for the immediate future (from one to four years), but value stocks tend to have less risk and more steady growth over a longer term.

Although the information in the previous section can help you shrink your stock choices from thousands of stocks to maybe a few dozen or a few hundred (depending on how well the general stock market is doing), the purpose of this section is to help you cull the so-so growth stocks to unearth the go-go ones. It’s time to dig deeper for the biggest potential winners. Keep in mind that you probably won’t find a stock to satisfy all the criteria presented here. Just make sure that your selection meets as many criteria as realistically possible. But hey, if you do find a stock that meets all the criteria cited, buy as much as you can!

When choosing growth stocks, you should consider investing in a company only if it makes a profit and if you understand how it makes that profit and from where it generates sales. Part of your research means looking at the industry and economic trends in general.

Making the right comparison

You have to measure the growth of a company against something to figure out whether it’s a growth stock. Usually, you compare the growth of a company with growth from other companies in the same industry or with the stock market in general. In practical terms, when you measure the growth of a stock against the stock market, you’re actually comparing it against a generally accepted benchmark, such as the Dow Jones Industrial Average (DJIA) or the Standard & Poor’s 500 (S&P 500).

If a company has earnings growth of 15 percent per year over three years or more, and the industry’s average growth rate over the same time frame is 10 percent, then this stock qualifies as a growth stock.

A growth stock is called that not only because the company is growing but also because the company is performing well with some consistency. Having a single year where your earnings do well versus the S&P 500’s average doesn’t cut it. Growth must be consistently accomplished.

Checking out a company’s fundamentals

When you hear the word fundamentals in the world of stock investing, it refers to the company’s financial condition and related data. When investors (especially value investors) do fundamental analysis, they look at the company’s fundamentals — its balance sheet, income statement, cash flow, and other operational data, along with external factors such as the company’s market position, industry, and economic prospects. Essentially, the fundamentals indicate the company’s financial condition. However, the main numbers you want to look at include the following:

Sales: Are the company’s sales this year surpassing last year’s? As a decent benchmark, you want to see sales at least 10 percent higher than last year. Although it may differ depending on the industry, 10 percent isa reasonable, general “yardstick.”

Earnings: Are earnings at least 10 percent higher than last year? Earnings should grow at the same rate as sales (or, hopefully, better).

Debt: Is the company’s total debt equal to or lower than the prior year? The death knell of many a company has been excessive debt. A company’s financial condition has more factors than I mention here, but these numbers are the most important. I also realize that using the 10 percent figure may seem like an oversimplification, but you don’t need to complicate matters unnecessarily. I know someone’s computerized financial model may come out to 9.675 percent or maybe 11.07 percent, but keep it simple for now.

Looking for leaders and megatrends

A strong company in a growing industry is a common recipe for success. If you look at the history of stock investing, this point comes up constantly. Investors need to be on the alert for megatrends because they help ensure your success.

What is a megatrend? A megatrend is a major development that has huge implications for much (if not all) of society for a long time to come. Good examples are the advent of the Internet and the aging of America. Both of these trends offer significant challenges and opportunities for our economy. Take the Internet, for example. Its potential for economic application is still being developed. Millions are flocking to it for many reasons. And census data tells us that senior citizens (over 65) will be the fastest growing segment of our population during the next 20 years. How does the stock investor take advantage of a megatrend?

In the wake of the 2000–2002 stock bear market, two megatrends hit their stride: rising energy prices and an overheated housing market. As of 2005, these two issues became major news items with tremendous ripple effects across the national economy. For the growth investor, strategy became clear. Find value-oriented companies with solid fundamentals that are well-positioned to benefit from these megatrends. What’s the result? From 2002–2005, many energy-related and housing-related stocks skyrocketed. As oil surpassed $65 a barrel and gasoline hit $3 a gallon, most oil and oil services companies saw their stocks go up 50 percent, 100 percent, and more during that three-year time frame. Housing stocks were even more impressive. In addition, companies that cater to these industries also prospered. Mortgage firms that were publicly traded also posted impressive gains.

Companies that have established a strong niche are consistently profitable. Look for a company with one or more of the following characteristics:

A strong brand: Companies such as Coca-Cola and Microsoft come to mind. Yes, other companies out there can make soda or software, but a business needs a lot more than a similar product to topple companies that have established an almost irrevocable identity with the public.

High barriers to entry: United Parcel Service and Federal Express have set up tremendous distribution and delivery networks that competitors can’t easily duplicate. High barriers to entry offer an important edge to companies that are already established.

Research and development (R&D): Companies such as Pfizer and Merck spend a lot of money researching and developing new pharmaceutical products. This investment becomes a new product with millions of consumers who become loyal purchasers, so the company’s going to grow.

Noticing who’s buying and/or recommending the stock

You can invest in a great company and still see its stock go nowhere. Why? Because what makes the stock go up is demand — having more buyers than sellers of the stock. If you pick a stock for all the right reasons, and the market notices the stock as well, that attention causes the stock price to climb. The things to watch for include the following:

Institutional buying: Are mutual funds and pension plans buying up the stock you’re looking at? If so, this type of buying power can exert tremendous upward pressure on the stock’s price. Some resources and publications track institutional buying and how that affects any particular stock. Frequently, when a mutual fund buys a stock, others soon follow. In spite of all the talk about independent research, a herd mentality still exists.

Analysts’ attention: Are analysts talking about the stock on the financial shows? As much as you should be skeptical about an analyst’s recommendation (given the stock market debacle of 2000–2002), it offers some positive reinforcement for your stock. Don’t ever buy a stock solely on the basis of an analyst’s recommendation. Just know that if you buy a stock based on your own research, and analysts subsequently rave about it, your stock price is likely to go up. A single recommendation by an influential analyst can be enough to send a stock skyward.

Newsletter recommendations: Independent researchers usually publish newsletters. If influential newsletters are touting your choice, that praise is also good for your stock. Although some great newsletters are out there and they offer information that’s as good or better than the research departments of some brokerage firms, don’t use a single tip to base your investment decision on. But it should make you feel good if the newsletters tout a stock that you’ve already chosen.

Consumer publications: No, you won’t find investment advice here. This one seems to come out of left field, but it’s a source that you should notice. Publications such as Consumer Reports regularly look at products and services and rate them for consumer satisfaction. If a company’s offerings are well received by consumers, that’s a strong positive for the company. This kind of attention ultimately has a positive effect on that company’s stock.

Learning investing lessons from history

A growth stock isn’t a creature like the Loch Ness monster — always talked about but rarely seen. Growth stocks have been part of the financial scene for nearly a century. Examples abound that offer rich information that you can apply to today’s stock market environment. Look at past market winners, especially those of the 1970s and 1980s, and ask yourself, “What made them profitable stocks?” I mention these two decades because they offer a stark contrast to one another. The ’70s were a tough, bearish decade for stocks, while the ’80s were booming bull times. Being aware and acting logically are as vital to successful stock investing as they are to any other pursuit. Over and over again, history gives you the formula for successful stock investing:

Pick a company that has strong fundamentals, including signs such as rising sales and earnings and low debt.

• Make sure that the company is in a growing industry.
• Be fully invested in stocks during a bull market, when prices are rising in the stock market and in the general economy.
• During a bear market, switch more of your money out of growth stocks (such as technology) and into defensive stocks (such as utilities).
• Monitor your stocks. Hold on to stocks that continue to grow, and sell those stocks that are declining.

Evaluating the management of a company

The management of a company is crucial to its success. Before you buy stock in a company, you want to know that the company’s management is doing a great job. But how do you do that? If you call up a company and ask, it may not even return your phone call. How do you know whether management is running the company properly? The best way is to check the numbers. The following sections tell you the numbers you need to check. If the company’s management is running the business well, the ultimate result is a rising stock price.

• Return on equity

Although you can measure how well management is doing in several ways, you can take a quick snapshot of a management team’s competence by checking the company’s return on equity (ROE). You calculate the ROE simply by dividing earnings by equity. The resulting percentage gives you a good idea whether the company is using its equity (or net assets) efficiently and profitably. Basically, the higher the percentage, the better, but you can consider the ROE solid if the percentage is 10 percent or higher. Keep in mind that not all industries have identical ROEs. To find out a company’s earnings, check out the company’s income statement. The income statement is a simple financial statement that expresses the equation: sales less expenses equal net earnings (or net income or net profit).

To find out a company’s equity, check out that company’s balance sheet. The balance sheet is actually a simple financial statement that illustrates total assets minus total liabilities equal net equity. For public stock companies, the net assets are called “shareholders’ equity” or simply “equity.”

• Insider buying

Watching management as it manages the business is important, but another indicator of how well the company is doing is to see whether management is buying stock in the company as well. If a company is poised for growth, who knows better than management? And if management is buying up the company’s stock en masse, then that’s a great indicator of the stock’s potential.

Making sure a company continues to do well

A company’s financial situation does change, and you, as a diligent investor, need to continue to look at the numbers for as long as the stock is in your portfolio. You may have chosen a great stock from a great company with great numbers in 2003, but chances are pretty good that the numbers have changed since then.

Great stocks don’t always stay that way. A great selection that you’re drawn to today may become tomorrow’s pariah. Information, both good and bad, moves like lightning. In late 2000, analysts considered Enron a cream-of-thecrop stock, and they fell over themselves extolling its virtues. Even the thencelebrated market strategist Abby Joseph Cohen called Enron her number one choice in the energy sector as late as September 2001. Yet Enron shocked investors when it filed for bankruptcy in December 2001. Its stock price fell from $84 in December 2000 to a staggering 26 cents a share (yikes!) in October 2001! Keep an eye on your stock company’s numbers!