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Fundamentals:
To make a decision on which stocks to purchase and when, investors often begin by looking at certain measurements and ratios called fundamentals which are the statistics of a company's profits, loss ratios, equity ratios, and debt ratios. Most of these are calculated by professional analysts and accountants who study companies and publish their reports quarterly for the benefit of shareholders, potential investors, the IRS, and government agencies to see and study. They can be found at popular websites such as finance.yahoo.com or at discount brokerage firms such as Scottrade or TD Ameritrade. We will look at a few fundamentals here.

A great mutual fund investor, Peter Lynch, once said: "what makes a company valuable, and what will make it more valuable tomorrow than it is today.... It always comes down to earnings and assets. Especially earnings."²⁰ He indicates that if investors will look into the story the stock is telling and answer these five questions, they can predict future earnings growth and future company growth. Are they; "reducing costs, raising prices, expanding into new markets, selling more products in an old market, or revitalizing, or closing losing operations."²¹

Earnings Per Share (EPS)
Investors judge earnings by turning it into a ratio called earnings per share (EPS). Earnings per share is found by calculating a company's net profits or earnings divided by the number of shares outstanding.²² It's calculated by the quarter (four in a year). Future earnings are predicted by the quarter as well. Investors will compare this quarter earnings by last years by quarter earnings. And compare forecasted earnings to present earnings in making judgments about profitability and growth.

Price To Earnings (PE)
Investors also look at a number called price to earnings (PE) to assess what is undervalued or overvalued. Price to earnings is the price of a stock divided by the earnings per share.²³ For an example Suppose a stock is trading at $48 per share and has earnings of $4 per share. This would create a PE of $12. So in essance for every $12 invested we should expect the company to earn $1. The smaller the PE the more the stock is considered undervalued and a bargain. The higher the ratio the more likely the stock could be experiencing tremendous growth by the phenomenon of explosive earnings and forecasted earnings. But at some point the cycle of growth will wane and the stock will be overbought at which time it will decline. Peter Lynch, a buy and hold investor, said, "A company with a high p/e must have incredible earnings growth to justify the high price that's been put on the stock… remember to avoid stocks with excessively high ones... with few exceptions an extremely high p/e ratio is a handicap to a stock."²⁴

Growth investors look for a high PE which indicates a company is expected to increase performance and is earning money. They see PE as an end result of explosive growth (not causing it)²⁵. You're buying it's supposed future prospects and potential. Generally value investors look for stocks with a lower PE ratio. These companies are considered undervalued. They can often be found in the lowest 10% PE for all stocks (which is roughly less than a PE of 10). The strategy is to buy and hold. It may take some time for the stock to gain favor with the market once again and come back up. It could be even take years. But be careful with this for many stocks with a low PE are down because they are poor performers and will likely stay down.

Price to Earnings Growth (PEG)
Another indicator used by value investors is price to earnings growth (PEG) which is price to earnings (PE) divided by earnings per share growth, forecasted. PEG should be less than one implying that the stock is undervalued. If it's greater than one it might be overvalued. Another way to look at it is if eps growth is greater than PE then the stock price should go up. It's considered a bargain for value investors. Ideally look for companies whose PEG is between 0.5 to 1.00 and definitely sell if PEG > 2.00. PEG is thought to be more useful in valuing smaller companies (small cap) because most often they haven't grown and amassed tangible assets like larger companies (large cap) have. ²⁶

For growth investors a ratio of two or larger PEG is considered too expensive for a stock and it is considered wise to sell mainly because mutual and hedge fund operators (those that manage most of the money) often sell when the ratio is over two.²⁷

Return on Equity
There is also the indicator called return on equity (ROE) which is the net income divided by shareholder's equity. This is a measure of company profits relative to the amount shareholders have put into it. Look for companies that are the highest in their sector. At least 15%, but 20% or more is ideal.²⁸ Companies with a higher value tend to generate more cash internally.

Return on Assets
Also there is return on assets (ROA) which is a measure of net income divided by assets (assets comprising debt and equity). This is another important measure that allows investors to measure earnings against the assets they own and operate. Generally the higher the ratio the better. But beware of companies with excessive debt. These companies are often riskier than those with little debt.

Debt:
The current ratio is another popular indicator showing a company's ability to pay it's bills. It is found by dividing current assets by current liabilities. Current assets are everything a company uses up and replenishes such as inventory. Current liabilities are short term debts due within one year. This ratio is also helpful in allowing investors to see the company's ability to pay debts quick or take advantage of opportunities.²⁹ The Higher the ratio the better. Peter Lynch has said: "A normal companies balance sheet should have 75% equity to 25% debt… More than anything else, it's debt that determines which companies will survive and which will go bankrupt in a crisis. Young companies with heavy debt are always at risk."³⁰

The quick ratio which is also a very helpful indicator, is measured by dividing a company's cash and equivalents by its short term debt or current debt. It is useful in determining a company's ability in dealing with short term needs.³¹ And once again the higher the ratio the better.

Value Investors:
Before we go further let me briefly define two major types of investments that are used by individual investors who buy stocks and by professionals who manage investment accounts like 401(k)s and IRAs. There are value investments and growth investments. Value investments are stocks bought at what seems a bargain price. The hope is that the stock has been undervalued by the market (oversold) and will come back in favor with investors and rise. Thereby reflecting its true market worth.

Growth Investors:
The second major type of investment used by investors is called growth investments.These are stocks that are generally priced higher and have a history of going up in the recent past. They may appear overbought by value investors. The best growth stocks have 25% quarterly eps growth when compared with the previous year. And have at least 25% annual growth or more for the last three years.³² Look for these in "small aggressive, new enterprises...these are the big winners in the stock market...look for the ones that have good balance sheets and are making substantial profits. The trick is figuring out when they'll stop growing, and how much to pay for the growth." ³³ Of course with larger companies you can expect smaller quarterly growth but there should be at least 10% annual growth for the last 10 years. The formula that is generally used is: ((EPS forecasted) - (EPS current)) / (EPS current). Sales should be up at least 25% and increasing for the last three to four quarters.

Investors also look at the PE when choosing growth stocks. From 1953-1985 the best Growth Stocks began their ascent at a PE of about 20 and advanced to about 45. During the early 1990's the leaders began at about 36 and went into the 80s.³⁴ A very high PE indicate explosive growth but beware that if the PE is very high then the stock would certainly be more volatile. Companies that have a high earnings growth potential tend to have a higher PE but they have the challenge of continuing to develop new products and keep growing in market share and customer spending.³⁵ Because of this uncertainty these growth stocks have more inherent risk.