3 Areas to Check Out when Investing in Stocks

by Investing School on October 15, 2010

Buying stocks is very similar to the act of shopping. For many people, shopping at the mall or supermarket is a great experience, especially if they are with friends or family. Not only do they get to be with people they enjoy, a shopper gets to look at all kinds of merchandise to find exactly what they want to spend their hard earned money on.

Now consider yourself a shopper, but in a different kind of market, in this case, the equities (stock) market. In the stock market, buyers buy pieces of businesses instead of clothes or food, like at the mall or supermarket. A buyer could buy the stock of a grocery store or, for that matter, the company in the neighborhood which owns the local mall (and probably many others). Even more attractive to a stock buyer is the fact that owners of some stocks can get paid by the company with a cash or stock dividend, sometimes up to 4 times in a year. One might find it even better to be a stock owner than a mall shopper if a company the shopper owns can grow its revenues and profits from X to 10X or 20X over a number of years. In this example, the price of the stock may go from $5 per share to $15 or $20 a share or even more. The fortunate buyer of the stock has merchandise much more valuable than the price they paid for it.

The point is in the stock market buyers can own pieces of businesses which can make them money over a short or long period of time, without the owner standing on their feet working at a job. The real important issue to remember is becoming a good investor takes a great deal of knowledge, patience, and the ability to recognize undervalued companies based on assets, liabilities, revenues, operating profits, growth potential, and good management, to name a few characteristics. Oh by the way, an investor also needs money to invest in stocks, what a shock, huh?

So, let’s look at a few basic rules one should think about when examining a company’s financial statements to get a feel for what to look for, and what not to buy. First, there are three parts to a company’s financial statements:

  1. The balance sheet, which gives an investor the assets and liabilities of a business at one specific time.
  2. The income statement shows the revenues, expenses, operating income, and net income over a period of time, usually 3 months, 6 months, 9 months, and one year.
  3. The cash flow statement reconciles differences in net income on the income statement and assets and liabilities on the balance sheet to see how capital is flowing through the business.

In my opinion, the greatest investor who has ever lived is Warren Buffett, the Oracle of Omaha, who is one of the richest men in the world. He has a saying: “There are two rules in investing. Rule #1 is do not lose money. Rule number two is do not forget rule number #1.” In the spirit of these rules, a great place to start examining a company is on the balance sheet. If one looks at current assets and finds cash and short term investments, take those two numbers and add them up. On the balance sheet is also liabilities- look for short term and long term debt. Take those two numbers and add them up. If one compares the total cash on the balance sheet to the total debt owed by the company, you ideally want to see total cash much greater than total debt levels. The greater the amount of cash versus the total debt, generally the safer the company is for an investor. If debt levels are greater than 3-5x the cash level, the more an investor might start looking for another company to research.

Second, an investor should try to look for businesses which generate positive operating income from the business operations. In order to find the operating income number, an analyst should go to the income statement, and in the middle of the page, after one sees gross profit, and after total operating expenses, there should be the line which reads operating income. Operating income is merely how much income a business earns before paying interest and taxes. If a company cannot earn money from its operations before paying interest and taxes, without selling assets, again one should think hard about owning the stock. Conversely, the more operating income the company generates, the more an investor should look into other parts of the business for a potential purchase of stock.

Third, an investor should look at price to earnings ratios, both forward and trailing, to get an idea of how much they are paying for the net income per share (or earnings) of a company. In addition, they should compare the P/E ratio of their potential purchase to other competitors in the industry to get an idea of relative value of their stock purchase. For example, if the price of a company is $20 per share and the net income is 2$ per share, the P/E ratio would be 20/2=10. All this means is an investor is paying 10$ for every dollar of earnings. The goal of investors is to get the most they can for their capital in any company they buy. One should try and find companies whose P/E ratio’s are low, usually the lower the better. By doing so, usually the investor will buy a business where the assets and operations are cheap. For example, if the supermarket industry has three companies, and the one you are considering buying has a forward P/E ratio of 15, and two other competitors have forward P/E ratios of 20 and 25, the investors purchase is 25% and 40% cheaper on a P/E basis than its competitors.

Keep in mind there are many valuation metrics which can be used to evaluate the price one is paying for a company and an investor should probably use a variety of these techniques to determine how attractive the price of the purchase is. The great thing about investing is there are thousands of companies to choose from in many different industries: the internet, media, gaming, retail, health care, oil, gold, silver, infrastructure, and on and on and on. Like any good shopper, great investors look at all kinds of companies in many industries to determine what they want to buy. I hope the article helped provide some information on shopping in the stock market and why it might be a way to help build an interest in investing. Thanks for reading.

This is a guest post by Yale Bock, CFA, President, Y H & C Investments. If you like this post and would like more information, check out www.y-hc.com.

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{ 1 comment… read it below or add one }

Bob November 24, 2010 at 6:47 am

Great Primer, Excellent Common Sense piece and broken down for even the most novice person. Thank you — I would like to pass this on. Would that be OK?

Bob G


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