Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

4 Ways You Can Spot a Healthy Company

Instead of relying on full-service brokers and the mainstream business press for investment direction, many investors are deciding to take matters into their own hands.

With a cornucopia of information freely available on the Internet, there is nothing stopping you from producing your very own, independent, unbiased investment analysis. By doing your own research you may be able to separate yourself from the herd of lemmings the next time they start charging toward the cliffs.

The first step in becoming an investment sleuth is to continually seek out educational content (you're reading this, so you're already on the right track).

But to sharpen your understanding of any company, you need to get familiar with its financial statements. With just a little manipulation, the information contained in financial statements can ultimately reveal to you the risk level and profit potential of your prospective investment.
 
Financial statements are a part of every company's annual and quarterly reports. Company web sites generally have an investor relations link that will direct you to financial statements, historical stock prices, press releases, and a plethora of other good information. You can also go to www.sec.gov to see the financial statements that all publicly-traded companies are required to file.

When we say "financial statements" we're talking about the balance sheet, the income statement and the cash flow statement. The balance sheet shows you the firm's assets and debts; the income statement shows you how well the firm increased sales and minimized expenses; and the cash flow statement shows you how the company generated and/or used cash throughout the year.

My favorite tools make up a set of simple but powerful indicators derived from line items you can find in every company's financial statements.  I'll show you how to calculate and interpret these indicators, and then I'll highlight five healthy companies that met my criteria.

Here are my favorite financial characteristics of a healthy company:

Profit margins on operations (operating margins) are rising and higher than the industry average.

operating margin is calculated by dividing operating earnings by total sales. Both of these line items are found on the income statement.

Operating margin paints a picture of the ongoing profitability of a company’s business operations. Healthy profit margins reflect a strong market position and an efficient process. Look for profit margins within 10 percent of their record highs.

Healthy free (or excess) cash flow.

Free cash flow (FCF) is calculated by subtracting capital expenditures from operating cash flow.  Both of these line items are found on the cash flow statement.
 
FCF can be thought of as the excess money available to the company after it invests in itself.  A healthy company will almost always generate positive net cash flow, even in years when profits are terrible.

Demonstrated earnings growth.

You can calculate how fast earnings are growing with this formula: ( today's earnings - last quarter's earnings ) / last quarter's earnings. Earnings are found on the income statement.

Looking at a firm's past earnings performance can give you an indication of how it copes during recessions. Preferably, management was able to grow quarterly earnings even during economic downturns.

A reasonable price-to-earnings ratio (P/E).

Look at the company’s projected earnings per share for the next 12 months. Divide this by the current stock price per share. In most cases, the P/E shouldn’t exceed the stock's earnings growth rate by more than 25 percent.

Now, here’s a list of five great companies that passed our rigorous metrics: relatively high profit margins, plenty of Free cash flow, demonstrated quarterly earnings growth and a reasonable P/E ratio.

Using the above basic criteria as a starting point, you can explore these and other fundamentally “healthy stocks” further on your own.