Welcome to another edition of “Stock Picking 101” at mycomputerninja.com. My second lesson in the series is going to cover a stock picking method that helps in selecting small market capitalization stocks. As I mentioned in Lesson 1, these stock picking methods can be found as a part of the set of preset screens in the free yahoo.com stock screener application.
The aim of this series of lessons is to give speculators some interesting criteria with which to find new stocks, hopefully before everyone else finds them. Not only will I provide the criteria for picking the stocks, but I will also explain why these methods may or may not work.
The Criteria for picking a small market capitalization stock are as follows:
- Market capitalization between $250 million and $1 billion dollars
- Price to earnings ratio of less than or equal to 10
- Quick ratio greater than or equal to 1.0
The first criteria, market capitalization, is defined by Wikipedia as “A measurement of corporate or economic size equal to the stock price times the number of shares outstanding of a public company. ” Market capitalization is easy to calculate by hand, and in most cases, is provided for you as part of a summary of the stock. Market capitalization numbers contain information on the overall worth of the company in investors eyes. This provides a number with which analysts could value the company. An interesting way to explain it is to look at Google’s market capitalization, currently hovering around $162 billion dollars. Not a small cap stock, but its interesting to see. You can ask yourself, “is search, and the advertising Google does with search, worth $162 Billion dollars.” Of course, this is a very subjective question, and I leave it to you to decide.
The second criteria, price to earnings ratio, is again defined by Wikipedia as “a measure of the price paid for a share relative to the income or profit earned by the firm per share. ” Price to earnings, or P/E is calculated by taking the price per share and dividing it by the earnings per share of the stock. Effectively, this calculation defines how many dollars you have to spend to receive $1 in profit. It is easy to see why a lower P/E is more attractive. A stock with a P/E of 20 means you have to spend $20 to realize $1 in income, or that it will take 20 years to earn back your original investment. It is not so easily cut and dried, as the P/E is generally a trailing ratio, and as we all know, “Past performance is no indication of future returns”. There are criteria to define a “Forward P/E”, which use estimates of future earnings, but these can be wildly inaccurate and subject to manipulation.
The last criteria to discuss in using these criteria is the “quick ratio”. Once again, I return to Wikipedia for a concise definition. “Quick ratio measures the ability of a company to use its near cash or quick assets to immediately extinguish its current liabilities.” Effectively, this criteria defines if a company has enough cash on hand to extinguish all of its outstanding debt. This criteria is set at 1.0 or greater because at lower than 1, a company would have difficulty paying back its outstanding debt with liquid assets. This criteria can be calculated by finding a number representing current assets, and dividing it by current liabilities. Using my favorite whipping boy, Google, a quick run through the Yahoo Stock Screener reveals a quick ratio of 10.693. This is good, because it means that Google has plenty of extra cash on hand.
With that, I conclude Lesson #2 on picking stocks. Stay tuned, Lesson #3 is coming up soon.
The admin of this site and writer of this post, Jon Steege, is not a financial analyst or a stock broker. He is a Computer Scientist with a knack for data analysis. He does not own Google stock, and does not make any recommendation as to the stability, or lack there of, of any stock mentioned. Buy smart, but buy at your own risk.
See other posts in this series by visiting the investing section on mycomputerninja.com