Every investor would love to stumble upon the perfect stock. But will you ever really find a stock that provides everything you could possibly want?

One thing's for sure: You'll never discover truly great investments unless you actively look for them. Let's discuss the ideal qualities of a perfect stock, then decide if VMware (NYS: VMW) fits the bill.

The quest for perfection
Stocks that look great based on one factor may prove horrible elsewhere, making due diligence a crucial part of your investing research. The best stocks excel in many different areas, including these important factors:

  • Growth. Expanding businesses show healthy revenue growth. While past growth is no guarantee that revenue will keep rising, it's certainly a better sign than a stagnant top line.
  • Margins. Higher sales mean nothing if a company can't produce profits from them. Strong margins ensure that company can turn revenue into profit.
  • Balance sheet. At debt-laden companies, banks and bondholders compete with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
  • Money-making opportunities. Return on equity helps measure how well a company is finding opportunities to turn its resources into profitable business endeavors.
  • Valuation. You can't afford to pay too much for even the best companies. By using normalized figures, you can see how a stock's simple earnings multiple fits into a longer-term context.
  • Dividends. For tangible proof of profits, a check to shareholders every three months can't be beat. Companies with solid dividends and strong commitments to increasing payouts treat shareholders well.

With those factors in mind, let's take a closer look at VMware.

Factor

What We Want to See

Actual

Pass or Fail?

Growth 5-Year Annual Revenue Growth > 15% 36.7% Pass
  1-Year Revenue Growth > 12% 29.7% Pass
Margins Gross Margin > 35% 83.8% Pass
  Net Margin > 15% 19.8% Pass
Balance Sheet Debt to Equity < 50% 8.7% Pass
  Current Ratio > 1.3 2.62 Pass
Opportunities Return on Equity > 15% 17.2% Pass
Valuation Normalized P/E < 20 96.75 Fail
Dividends Current Yield > 2% 0% Fail
  5-Year Dividend Growth > 10% 0% Fail
       
  Total Score   7 out of 10

Source: S&P Capital IQ. Total score = number of passes.

Since we looked at VMware last year, the company has improved by two points. Better net margins have resulted in a stronger return on equity, and the stock has outperformed the overall market as a result.

Cloud computing has become more popular than ever as companies look for ways to cut costs and gain efficiency with their IT systems. Tech giants Microsoft (NAS: MSFT) and Amazon (NAS: AMZN) have been duking it out on the cloud-provider front for a while now, as Amazon's EC2 creates a useful cloud-server infrastructure for customers while Microsoft has aimed at pre-built applications that limit flexibility but can streamline use.

For its part, VMware has taken advantage of that trend with its "hybrid cloud" model that lets businesses set up virtual machines, producing cost savings and taking advantage of other unused computing resources. Its partnership with Cisco Systems (NAS: CSCO) gives it the ability to offer bundled solutions that include VMware platforms combined with Cisco equipment.

But VMware is losing a key executive with the June 1 departure of CFO Mark Peek, who is going to a privately held cloud-computing company to take on the CFO reins there. With shares trading at very high multiples, any whiff of bad news can send the stock skidding, but investors seem to have regained confidence in VMware's prospects even without Peek.

Investors shouldn't look for VMware to boost its score beyond this point in the near future. It'll take a while for earnings to catch up with its growth, and paying a dividend doesn't make much sense right now -- especially given that parent company and majority-owner EMC (NYS: EMC) doesn't have a big need for cash. In the long run, though, VMware could have what it takes to get to perfection.

Keep searching
No stock is a sure thing, but some stocks are a lot closer to perfect than others. By looking for the perfect stock, you'll go a long way toward improving your investing prowess and learning how to separate out the best investments from the rest.

VMware isn't the perfect stock, but we've got some ideas you may like better. Let me invite you to learn about three smart long-term stock plays in the Fool's latest special report. It's yours for the taking and is absolutely free, but don't miss out -- click here and read it today.

Click here to add VMware to My Watchlist, which can find all of our Foolish analysis on it and all your other stocks.

At the time this article was published Fool contributor Dan Caplinger doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Amazon.com, Cisco Systems, Microsoft, and EMC. Motley Fool newsletter services have recommended buying shares of Microsoft, Amazon.com, and VMware, as well as creating a bull call spread position in Microsoft. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool has a disclosure policy.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.


Increase your money and finance knowledge from home

Introduction to Preferred Shares

Learn the difference between preferred and common shares.

View Course »

Behavioral Finance

Why do investors make the decisions that they do?

View Course »

Add a Comment

*0 / 3000 Character Maximum