Investors who focus on these three criteria together, tend to do a better job of picking stocks. Though this method carries no guarantee, it's as good a way as any to judge the financial health of companies and make judgments about expected returns over the long haul. Analysts put out estimates of expected returns, but ultimately, you must come up with your own figures. Focusing on these three economic concepts can help you do this.
For this method to work, you must apply it consistently, using discipline and avoiding the pitfall of letting fear or greed cloud decisions. Individual investors who stick to a well-reasoned, well-defined process — running their portfolios like a business — tend to do much better.
Many investors end up buying stocks in un-businesslike ways. For example, if you hear about a great stock at a party, odds are that you're late for the party of share-price growth. You may find that such stocks have good earnings but, because the prices have been pushed up by their current popularity, they have astronomical P/E ratios. So their earnings are probably too expensive to justify a buy. Commonly, people buy these "hot," priced-up stocks, only to sell them later when the air comes out; they buy high and sell low. One of the toughest things for most individual investors to understand is that you can't accurately predict future performance based on the present or recent past. A company's future performance is more likely to resemble its long-term past average. Investors who focus on the recent high performance can easily overpay.
Stock returns tend to be associated with dozens of financial, competitive and market factors. Instead of worrying about all these complexities, you can assess a company's potential returns by assessing its financial genetic code. This code is reflected by its earnings growth, P/E ratio and dividend record.
Ted Schwartz, a Certified Financial Planner®, is president and chief investment officer of Capstone Investment Financial Group (http://capstoneinvest.net). He advises individual investors and endowments, and serves as the advisor to CIFG Funds. Because Schwartz has a background in psychology and counseling, he brings insights into personal motivation when advising clients on achieving their wealth management goals. Schwartz holds a B.A. from Duke University and an M.A. from Oregon State University. He can be reached at email@example.com.