In making investment decisions that meet the dual
criteria of limiting risk to a level you're comfortable with
and providing the opportunity to achieve the return you're
seeking, you'll want to evaluate the company that has issued
the security you're considering.
The process of examining a company's management, balance
sheet, income statement, and business outlook is called
fundamental analysis. It's the primary tool for determining what
to buy.
If a company's earnings per share aren't growing, if
its current asset ratio — also known as net working capital
— is limited, if its debt ratio is too high, or if it doesn't
have enough cash on hand to operate smoothly or meet its interest
expenses, chances are that your risk in investing outweighs the
likelihood of an acceptable return. On the other hand, if these
fundamentals are solid, then your chances of achieving the desired
return are improved, though not guaranteed.
P/E ratio
You can use a number of fundamental tools to measure a stock's
valuation. Among the most common is the
price-to-earnings ratio (P/E). You calculate P/E, also known as a stock's
multiple, by dividing the share price by the current earnings
per share. If the result is higher than the market average and
the average for the stock's sector, it may mean investors
are confident that the stock is strong. But there's always
the danger that the stock is priced higher than its future earnings
may justify, setting it up for a drop in value.
There's also a concern if the P/E is lower than the norm.
While it may be the sign of a great value, it may also indicate
that the company is in serious trouble. That's why experts
caution you to use P/E in combination with other indicators, and
not as the sole deciding factor.
Thomas J. Dorsey, President and
co-founder of Dorsey, Wright &
Associates
Thomas J. Dorsey, President and
co-founder of Dorsey, Wright &
Associates 
