Many investors have a particular method for selecting the stocks in which they invest. There are a number of theories that try to estimate the potential value of a stock, with each theory having several variations.

The following are the five primary methods of estimating the desirability of common stocks. Each has its proponents; popularity will vary, based on the most recent results.

Users of this method look at the value of a stock as a stream of dividends discounted by a required rate of return. For example, assume a stock pays a constant dividend of $2 per year ($.50 per quarter). If an investor wants to get a 12% per year return from the investment, he or she would pay $2 per .12 or $16.67 for the stock.

This example is, of course, overly simplified. Most companies increase their dividends over time. Analysis using this method usually factors in a growth rate for the dividend.

In order to properly evaluate stocks of small, high growth companies, the analyst would have to factor in a higher rate of dividend increases in the early years when the company’s earnings are exploding. After this initial period, a more modest dividend growth rate would be employed.

Unfortunately, this method is usually too simplified, and small errors in estimates of dividend increases can lead to great differences in projected stock prices.

Examining the Price/Earnings (P/E) Ratio is one of the most common methods for evaluating stocks. Essentially, this method asks how many times a given year’s earnings is an investor willing to pay for a stock. The P/E ratio for stocks varies greatly, just as the earnings prospects for these companies vary.

The better a company’s earnings outlook, the higher the P/E ratio should be. If one company’s earnings are expected to double over the next couple of years, while most other companies’ are likely to be flat, then investors are willing to pay for that company’s current earnings.

Several factors influence P/E ratios. In general, a stock will have a higher P/E if it has strong earnings growth expectations, non-cyclical earnings, a healthy balance sheet, little regulation and quality management.

These models look at the rate of change of earnings estimates or reported earnings from one period to another. Anticipating the direction of change in earnings estimates is very important to analysts using these momentum models. The best stocks according to this method are those that will be seeing the greatest percentage increase in their earnings estimates.

Cash flow analysis has gained considerable importance over the last decade as companies have restructured and taken on more debt. Many items that affect a company’s reported earnings do not influence cash flow.

One example of the difference between earnings and cash flow is depreciation. Each year a company has to expense, or writes off, a portion of its plant and equipment until those assets are completely depreciated. Depreciation is subtracted from a firm’s earnings. However, depreciation has no effect on cash flow.

Since debt and dividends are paid with cash, and not earnings, many analysts concentrate on a company’s cash flow.

Some analysts look at a stock’s book value per share. This is done by taking the total book value of the firm and dividing that value by the number of shares of stock outstanding. Sometimes a company will acquire another company because it is cheaper to buy the assets of that company than build the assets from scratch.

This ratio can be deceptive. Usually, the book value of a company’s assets is considerably less than the assets’ market value. Therefore, it is a good idea to look not only at the book value of the company’s assets, but also the market value as well.

These five strategies are among the most prevalent. Each strategy has its own inherent strengths and weaknesses. Since one strategy might not apply well to a certain set of market conditions or a particular industry, it is best to use more than one strategy.

By evaluating a stock with a number of methods, an investor will get a broader perspective.

One advantage of mutual fund investing is that the funds investment managers perform this selection process. They have the research tools, computers and manpower. As complex as the selection of a stock may be, yet another problem is how to select when to sell a security once purchased.