Traders are wise to select stocks for trading based on a few powerful fundamental signals and trends. Fundamental analysts can find value in dozens of ratios and trend. However, three exceptionally valuable indicators, when used together, provide a 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 troubling ratio because the time periods are not the same for each side. Price is a technical indicator today, but earnings per share is fundamental and may be several months out of date. This is why the range and long-term 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 changes) 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. Dividend achievers also tend to perform at the top and to grow at a better than average rate. It also makes sense to check the dividend payout ratio (percentage of earnings paid in dividends), looking for consistency over several years.
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.
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