Evaluating Investment Potential: 4 Key Factors to Consider

Stock analysis can be as complicated as you want it to be. There are thousands of data points available to collect and consider. Sifting through this information may or may not be useful to making a timely, sound decision to buy, hold, or sell. While you shouldn't take shortcuts in investing, there are a few key (and easy to understand) indicators that nearly anyone can use to quickly analyze a stock. (See also: 15 Investing Tips From A #1 Wall Street Stock Picker)

There are two main issues to consider when conducting a review. First, evaluate the strength of the company; that is, determine whether the organization is worthy of owning. Then, figure out whether the price of a stock makes its purchase a wise investment decision.

In financial lingo, looking at the company and relevant economic conditions is called fundamental analysis; considering the stock price (and its possible movement in the near term) is referred to as technical analysis. Having bought great companies at too-high prices, I can attest to the need to consider the general health of a company and whether its stock is overvalued or undervalued in the market place.

Here are four easy and useful ways to evaluate a potential investment.

1. See the Company First-Hand

You can learn a lot about a company by visiting its facilities and talking to employees and customers. For example, shop at stores of companies in the retail sector. Notice whether the sales floor is buzzing with people or nearly empty. Look at its merchandise, comparing its branding, quality, and pricing to competitive offerings. Interact with employees to discern how well-trained and helpful they are.

For non-retailers, talk to friends and neighbors who are employees, customers, or vendors to get a sense of how the company operates and treats those who interact with the firm. Try the business's products and services. Ask industry professionals what they think about a company's product quality, service levels, and innovation.

Store visits, chats with employees, etc. can give you insights into an organization's general well-being. While you won't learn all that you need to know, you can contrast the corporate image with reality and determine if the company is worth further investigation.

2. Look at Financial Reports

Locate a company's financial statements to look at key statistics such as revenue, earnings, and cash flow over the past several years.

Access financial statistics directly at the SEC-EDGAR database (enter the ticker and find 10-K filings associated with annual reports). Alternatively, use online tools to dig into financial performance, such as Morningstar.com or Yahoo! Finance, where financial results and trends can be viewed under the Financials tab.

Ideally, you'll discover a company experiencing steady and strong growth with the capability of continuing this trend. Practically, though, finding a company with a perfect record is unlikely, as most have occasional setbacks, especially during recessionary periods. Still, you should look at the financials.

Notice whether:

1. net income is positive, indicating that the company is generating a profit;
2. revenue and earnings have grown over time; and
3. operating cash flow is positive and growing.

Past performance is not a guarantee but can indicate whether a company may continue to grow and deliver strong returns for shareholders.

3. Look at the P/E Ratio

The Price to Earnings Ratio (or P/E Ratio), which is the stock price divided by earnings per share, gives you an idea of whether you'll snag a bargain or pay a premium for the stock. This number might be referred to as the stock's valuation, which fluctuates due to real and perceived value.

Find this ratio for individual stocks at Morningstar, Yahoo! Finance, and Google Finance. Alternatively, look at charts for individual stocks inside the research section of your online brokerage firm.

According to The Motley Fool, "The median stock in the S&P 500 Index has historically had a P/E ratio of about 15." A lower number than average could indicate a good price whereas a higher number might mean the price is too high.

Many factors can affect this ratio, though, such as a slowdown in earnings or expected growth that is reflected in the stock price. Nevertheless, looking at the current P/E of a stock compared to its historical performance as well as its industry peers and the market in general can give you an idea about current valuations.

4. Watch the News

A glance at financial news can give you insights about a specific company as well as its industry and overall market activity, which can impact a stock's value.

You don't have to watch CNBC all day to get basic but meaningful information. Check Bloomberg.com online or via its mobile app or log in to your online brokerage account to receive headlines relating to global economies, view a market snapshot, note analyst ratings, and read company and industry news.

Take in updates about company earnings along with expansion plans and product introductions. Read about the industry's stagnation or rapid growth. Notice how your potential stocks grow or shrink in value based on movement of market indexes, which can reflect general investor sentiment about your picks.

Selecting stocks for your portfolio should involve making general observations, reviewing financial results, and getting a sense of what people are saying about its future. Then, make an investment decision by forming an opinion based on factors likely to affect the performance of the company and its stock price over the long term.

Do you buy and sell individual stocks? How do you evaluate a company?