While the macroeconomic environment may change over time, the characteristics of a good company stock do not.
This article will explain how to evaluate the company's financial characteristics and how to know if a company is a good investment.
Stable and growing earnings, high return on equity (ROE), high dividend yield and positive cash inflow are timeless indicators of companies' financial success that might be good investments.
Stable and growing earnings
Earnings are essential for a stock to be considered a good investment. Earnings can be evaluated in any number of ways, but three of the most prominent metrics are growth and stability.
Earnings growth is usually described as a percentage, in periods like year-over-year. The basic premise of earnings growth is that the current reported earnings should exceed the previously reported earnings.
Earnings stability is a measure of how consistently those earnings have been generated over time. Stable earnings growth typically occurs in industries where growth has a more predictable pattern.
Return on equity (ROE) measures the ability of a company's management to turn a profit on the money that its shareholders have entrusted it with.
ROE is calculated as follows:
ROE = Net Income / Shareholders' Equity
A high ROE could mean a company is more successful in generating profit internally.
Obviously, in the absence of any earnings, ROE would be negative. It is also important to examine the company's historical ROE to evaluate its consistency. A rising ROE suggests that a company is increasing its profit generation without needing as much capital.
High dividend yield
The dividend yield—displayed as a percentage—is the amount of money a company pays shareholders for owning a share of its stock divided by its current stock price. Mature companies are the most likely to pay dividends.
While high dividend yields are attractive, it's possible they may be at the expense of the company's potential growth. It can be assumed that every dollar a company is paying in dividends to its shareholders is a dollar that the company is not reinvesting to grow and generate more capital gains.
Positive cash inflow
The term cash flow refers to the net amount of cash and cash equivalents being transferred in and out of a company.
Cash received represents inflows, while money spent represents outflows. A company's ability to create value for shareholders is fundamentally determined by its ability to generate positive cash flows.
While all of these characteristics may lead to a sound investment in a good company, none of the metrics used to value a company should be allowed to stand alone.