Inexperienced investors tend to take one of two approaches to the stock market: They invest without doing any homework, based on a hot tip or the recommendation of a broker, or they avoid the stock market altogether.

The stock market has a well-deserved reputation for being risky in the short term, but what is less well known is that the returns of a well-diversified portfolio usually beat most other types of investment over the long term, and make stocks the least risky option for staying ahead of inflation over a period of years.

The safest way for a beginner to become involved in the stock market is to buy shares in a broad-based index mutual fund, investing the same amount at regular intervals (dollar cost averaging). By proceeding in this fashion, the investor avoids putting all of his money in the market just before a big drop, and automatically purchases more shares when the share price is lower. Moreover, he avoids the high fees that often come with actively managed funds.

Inevitably, though, as the investor gets more experience, he will want to try his hand at purchasing individual stocks. The two primary methods of analyzing stocks are fundamental analysis and technical analysis. The former relies on judging the financial soundness and future prospects of the underlying stock, while the latter is a method based on the theory that rising stocks continue to rise, and vice versa. Many systems of technical analysis exist, and elaborate claims are made for them, but most of the great investors of all time, such as Ben Graham, Warren Buffet, and Peter Lynch, rely on fundamental analysis. With that in mind, this article will focus on that method.

Here are some things to look at when judging stocks:

How big is the company? In general, smaller companies are more volatile than larger ones, but this is also where the biggest gains are usually made. Microcap stocks, and so-called penny stocks (those with a share price under $1.00) are usually best avoided, because they often are insufficiently capitalized to weather economic storms, and are so thinly traded that it may be difficult to sell them.

Is the company making money, and are its earnings increasing? Inevitably, share prices track company earnings. A company may have a wonderful new product, but unless it can make enough to develop it and cover its expenses, it may go bankrupt before the product sees the light of day. Companies whose earnings are steadily dropping should obviously be avoided, but a one-time drop in earnings that is unrelated to the overall prospects of the company can signal a buying opportunity. Earnings are subject to creative accounting, however, so look at the price/sales ratio as well. This number is harder to fudge, and therefore some believe it is more reliable.

How much are you paying for the company's earnings? This is usually measured by the P/E, or price/earnings ratio. It is difficult to compare stocks in different industries using this measure, because stocks in rapid-growth industries will naturally have higher P/E's than those in slower ones. For this reason, the P.E.G. ratio, which compares a company's P/E ratio to its predicted growth rate is sometimes a better measure for comparing stocks. Unfortunately, predicted growth does not always materialize, so other factors need to be considered as well.

How much debt does the company have? Companies carrying heavy debt loads are often unable to survive a temporary downturn in demand for their products. Look for debt/equity ratios of less than .5.

How much free cash flow does the company have? The less a company has to spend in equipment and raw materials to produce a dollar's worth of income, the better its free cash flow will be. High-demand product that are cheaply produced tend to make winning companies.

How efficiently is the company turning investor dollars into additional earnings? Look at the R.O.E. (return on equity) to determine this. A company's share price may be skyrocketing, but unless the company is using that money to increase earnings, the stock price will eventually crash and burn.

How much cash does the company have on hand? When you buy a company with a large cash cushion, you are getting a share of that cash, as well as a stake in the company. The same is true if the company owns valuable real estate or mineral rights.

Are insiders buying? Meaningful buying by company insiders is one of the best indicators that a company has good prospects. Insider trading is only illegal if an investor is privy to a specific development, such as a pending takeover, that is unknown to the general public, and trades on that basis. There is nothing illegal about an insider purchasing shares because he can see business is booming , or the stock is undervalued.. When several insiders reach the same conclusion, you might be wise to consider a purchase yourself.

Does the company pay a dividend, and how much? Generally, fast growers tend to pour all their cash back into the company, while slower growers pay large dividends. Which you prefer depends on your tolerance for risk, and on whether you need the income. Generally, a well-balanced portfolio will include both types of companies, as well as those in between.

Read all you can about the stock market, and invest based on whether you would like to own part of that company. Invest in industries you understand, and be patient. Over time, you may be pleased to see that you are outperforming many professional money managers.