4 Steps to picking the Right Stock

Four Step Analytical Steps to picking the right stock

by Matt Krantz usatoday Ask Matt June 5, 2008
I will run the stock through the four analytical steps we consider. But it isn't really necessary in your case. If you're not able to handle volatility, you shouldn't be invested in a financial company that's involved in mortgage-backed securities.

Step 1: Risk vs. reward. When you take a risk on a stock, you want to make sure you're properly rewarded. Downloading Annaly's history back to 1997, and including the current dividend yield of 11%, we see the company generated an average annual compound rate of return of 14.9%. That is a healthy return if you consider the S&P 500 has returned more than 10% annualized over the same time period, says IFA.com.

But to beat the S&P 500, you accepted high risk — standard deviation — of more than 100 percentage points. That's about 400% greater than S&P 500's risk during the same period. So to get a 35% higher return you accepted 400% higher risk. Not a good deal.

Step 2: Measure the stock's discounted cash flow. Some investors decide if a stock is pricey by comparing its current price to the present value of its expected cash flows. It's a complicated analysis made simple with a system from NewConstructs. When we run Annaly's stock, we find it's rated "neutral." In other words, the current stock price is roughly equal to what the company is expected to generate in cash over it's lifetime. Using this analysis, it would appear Annaly's stock is fairly valued.

Step 3: Compare the stock's current valuation to its historical range. BetterInvesting's Stock Selection Guide can help. If the company can increase earnings 6% a year the next five years, as analysts expect, that would put the stock in the "buy" range. That's a green light for investors who believe the price-to-earnings ratio will return to historical norms.

Step 4: Check the company's financial health. Before investing in any company, you want to make sure it's in good financial shape. A quick way to check is to look at where it falls on the USA TODAY Stock Meter, which ranks stocks from conservative (1) to aggressive (5). Annaly scores a solid 2.3 here. You can get a Stock Meter score for almost any stock by going to money.usatoday.com and putting the stock's ticker symbol or company name into the Get a Quote box.

The bottom line?

The fact you're writing me after the stock fell 30%, tells me you're not prepared to handle this kind of risk. Volatility works both ways, and if you don't want to endure the severe downs that come with this stock's ups, it's probably not for you

Matt Krantz is a financial markets reporter at USA TODAY and author of Investing Online for Dummies. He answers a different reader question every weekday in his Ask Matt column at money.usatoday.com. To submit a question, e-mail Matt at mkrantz@usatoday.com. Click here to see previous Ask Matt columns.