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by Douglas Gerlach
Buying stocks you can hold in your portfolio for years is quite a different process than buying a stock you expect to sell next week. Of course, there is no guarantee that once you buy a stock with an eye to the long-term, you'll never have to sell it. But identifying companies that are more likely to turn in a solid performance over the next five to ten years isn't that difficult if you focus on three key areas: Growth, Quality, and Value.
Going for Growth
Long-term stock investors hold one truth to be self-evident - that one factor can usually drive a stock's share price higher and higher. That single factor is the growth of a company's earnings (the company's profits). In turn, a company's overall growth is ultimately dependent on the company's growth of sales or revenues. Companies that sustain earnings growth over the years are likely to be rewarded with ever-rising share prices. On the flip side of the equation, companies with no profits can rarely be considered solid long-term holdings because it's impossible to predict when (or if) those companies will be able to maintain growth over the years or even stay in business.
A company reports its earnings per share, or EPS, each quarter and each year on its financial statements, which are summarized in SEC Filings reports. Other financial news web sites report the EPS growth in the past as well as the future growth expected by analysts.
If a company demonstrates the ability to grow its earnings over time, you can reasonably expect similar performance in the future. Just remember, though, that since most companies experience a slowdown in growth as they get larger, you should expect the growth of even the best companies to slow a bit over the years.
Growth is the first benchmark to look for as you go through the process of selecting a stock to buy. If the company you're researching doesn't have a solid history of earnings growth, consider it a candidate for speculation, not investment. A company may increase its sales year after year, but unless it also consistently demonstrates its ability to convert those revenues into earnings (or profits), you can't be sure the company will ever figure out how to stay in business.
The Quest for Quality
Once you've identified that a company is growing at a reasonable rate and should continue to do so in the foreseeable future, you'll want to make sure it is built upon a stable foundation of quality. Besides being able to grow its sales, the company has to be able to generate sufficient profits from those sales, and in addition, provide a sufficient return for its investors. Well-run companies that consistently achieve these two goals will normally outperform their peers.
If you are looking for stocks that you can buy and hold for many years, you want to own solid, well-run companies. There are many factors to consider that might be good indicators of a companys staying power. For instance, how do the company's profit margins stack up against those of their competitors? What is the experience of the management team and how long have they been with the company? Has the company generated a decent return for its shareholders over the years? Does the company have a strong brand? If you want to start learning more about a company before buying stock, you can start by visiting ShareBuilder's Research Center.
A View on Value
The final benchmark in your quest to purchase suitable long-term stock is value. While you should aim to own a portfolio of well-run growth stocks, you have to be able to recognize when a stock is selling for a bargain price, and when it's selling at a premium. Simply finding high quality, growing companies isn't enough to make a successful investment. You also have to know when it's the right time to buy a particular stock. Buying a stock when it is undervalued will enhance your possible total return. Knowing the potential upside of your investment, as well as the potential downside, is key to making sure you have a good shot at your target rate of return.
Unfortunately, stocks don't come with manufacturer's suggested retail prices, so you'll have to figure out for yourself when a stock is selling at a reasonable price, and when it's too expensive.
The most common measure of a stock's value is its Price/Earnings (P/E) Ratio. The P/E Ratio compares a stock's price to its earnings. It's often described as how much investors pay for each dollar of a company's earnings. P/E Ratios can be used to compare a stock's current price with its historical prices to give you an indication of how the stock is valued today compared to a point in the past. You can also compare the P/E Ratio of a stock to other stocks in its industry, or to the market in general, or to an industry average.
Another way investors determine whether a stock is a good value at its current price is to compare the stock's EPS growth rate to its P/E Ratio. Sometimes known as the PEG (P/E to Growth) Ratio, a stock that is selling for a P/E Ratio below or near its EPS Growth Rate might be a bargain. But if a stock's P/E Ratio is much higher than its EPS Growth Rate, the stock may be overvalued.
Putting Dollar-Cost Averaging to Work
Rather than trying to find the absolute best time and price to buy a stock, many investors use dollar-cost averaging to invest in shares over a long period of time. As we discussed in Lesson 1, dollar-cost averaging allows you to build a portfolio by investing a fixed amount on a monthly or other regular basis. When you use this method, you can choose companies that are well-managed and growing nicely, and then invest in their shares on a continual basis - without worrying whether the stock is currently undervalued or overvalued. Your dollars automatically buy fewer shares when the price of a stock is high and more shares when the price is low. As we mentioned in Lesson 1, it's important to recognize that dollar-cost averaging doesn't assure profits or protect you from investment losses. You should consider your financial ability to continue investing in a declining market.
Dividends Can Add to Your Returns
For dividend-paying stocks, the dividend can provide an extra boost to your investment return and should also be considered. The amount of dividends a stock pays on an annual basis is its yield. A stock with a yield of 2.3% is expected to pay dividends that amount to 2.3% of the current purchase price of the stock. You can compare the yield to the interest you receive on an account at your bank, but it's important to note that dividends aren't guaranteed and could rise or fall.
Wrapping Up
By following the three benchmarks of Growth, Quality, and Value, you have a better shot at investing successfully in common stocks and growing your portfolio. You can learn a great deal about a company by reading its financial statements, press releases, news stories, annual reports, and other documents. As you become more experienced, you'll learn how best to interpret the information you discover in those documents in order to help you make better investing decisions.
Tomorrow:
Get Going!
In our final lesson, we'll help you get started buying stocks by opening a brokerage account and setting up your investing plan!
Further reading:
The Power of Dividend Reinvestment
Selling Stock in Real-time
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Topics This Issue
Going for Growth
The Quest for Quality
A View on Value
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Key Points
Long-term investors consider the growth of a company to be important because a company that grows its earnings and revenues over time will usually see its stock price rise accordingly.
You can usually find the Price/Earnings (P/E) Ratio of a stock wherever you can get a stock quote, in the newspaper or online. But you can also calculate it yourself by dividing the current price by the total Earnings Per Share of the last four quarters.
The PEG Ratio is one common way that investors determine whether a stock is reasonably valued. It's calculated by dividing the current P/E Ratio of a stock by the EPS growth rate of recent years.
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