How to be a better investor? Part 2

Questions every investor should ask before buying a stock

Ten questions every investor should ask before investing their hard earned money on any stock. Some of these may sound very elementary but if you take the time to answer them, your investment will be firmly grounded on long term prospects of a business rather than merely hoping for a hot hand.

  1. How does the company make money:
  2. If you don’t know what you’re buying, you’re hardly in a position to know what you should be paying for it. For example, their are few motor/car companies with almost 90% of their profit coming from loans they are providing to their customer instead of by selling vehicles. It does not make them bad stock to own but clearly it gives you better understanding of company’s risk and potential profits. company’s most recent annual report is required reading for any stock investor. There you’ll find a detailed description of a company’s business units and a breakdown of the sales and earnings figures that come from each. You’ll also find the answer to another crucial question: Are those earnings likely to be converted into cash for investors? While “net income” and “earnings per share” results may dominate the headlines in the business press, those figures are merely accounting concepts. It’s cold, hard cash that counts the most for shareholders–either in the form of dividends or reinvestment in the company’s operations that should lift the stock price. Turn to the statement of cash flow in the annual report and see if “Cash flow from operating activities” is positive or negative and whether it has been growing or declining. And check for this red flag: Are net earnings (as reported on the income statement) increasing while cash flow is declining? That could signal the use of creative accounting practices designed to goose paper profits that are of no benefit to shareholders.

  3. Are sales real:
  4. Thanks to accounting rules, a company can book sales revenue long before the cash actually comes in the door. (In the worst-case scenario, the cash never comes in the door.) And that can drastically affect the price you should be paying for the stock today. How can you tell if it’s the case? Often it’s clearly spelled out in the company filings. Take, for example, the case of tech company RSA Security. In the footnotes to its 2001 first-quarter financials, the company revealed that it had switched to an aggressive (but allowable) accounting method that permitted RSA to book sales revenue as soon as its software was shipped to distributors–why wait until an end user actually purchased it? Sometimes the warning signs of revenue manipulation are more subtle. For instance, be alert to companies whose sales are increasing at a far faster clip than those of its competitors. “If you can’t nail it down to something specific, like the company having a product they can’t keep on the shelves, you have a right to be suspicious,” says Jack Ciesielski, a forensic accountant and publisher of the highly regarded Analyst’s Accounting Observer. Be wary also of companies whose sole source of sales growth appears to come from gobbling up other companies. If a firm is averaging more than a couple of acquisitions a year, the motive is likely to be management’s desire to satisfy Wall Street’s short-term expectations. Over the longer haul, integrating a bunch of disparate companies into one can get messy and costly.

  6. it’s vital to know how it stacks up against the competition. The first readily accessible place to start your analysis is with sales figures. The best clue as to whether a company is beating its competitors is to simply watch year-over-year revenues. If the company is competing in a high-growth industry, are its sales growing as fast as those of its competitors? If it’s operating in a mature industry (like grocery retailing), have sales been holding their own over the past few years? And don’t forget the cost side of the equation when comparing a company with its rivals. Some companies, for example, are saddled with huge costs related to pension and health-care plans for their retirees–costs that put them at a severe competitive disadvantage.

  8. Some stocks are highly cyclical–in other words, the company’s performance is heavily dependent on the state of the economy. And cyclical stocks aren’t always the bargain they appear to be. For example, when the economy is on a downswing, the stocks of paper companies may begin to look incredibly cheap. But there’s a good reason for that: In tough economic times many businesses cut back on their advertising, newspapers and magazines get thinner, and paper companies therefore sell less paper. Of course, the opposite effect usually occurs coming out of a recession. Perhaps one of the most important factors to consider before buying a stock is the degree of price competition that exists within the industry. Price wars may be great for consumers, but they can quickly kill a company’s profits.

  10. you must give some thought to the worst-case scenarios it may face in the years ahead. For instance, a business that’s dependent on one customer for a huge chunk of its sales could collapse if it lost that customer. Some businesses are just inherently more risky than others. Consider the many profitless biotech companies whose shares have soared only to come crashing down after their wonder drug got shot down by the FDA.

  12. If you see one-time charges appearing in at least three of the past five years of income statements, you should be wary of the stock. As per research about 70% of the time, the stocks of companies falling into this category consistently underperform the benchmark index.

  14. Before you buy any stock, check out the amount of debt on the balance sheet–too much debt is risky, since a slowdown in sales or a hike in interest rates could threaten a company’s ability to make interest payments. And it greatly decreases a business’s margin for error. But debt isn’t the only way a company can get in over its head. Stock options–that great boon to executive compensation–come at a steep price to shareholders. In the footnotes to a company’s annual report, it must disclose what earnings would have been had options been factored into the equation.

  16. Assessing the quality of a company’s leadership team is not always a straightforward exercise for the average outsider. Still, experts say there are some classic indicators that investors should consider before buying a stock. You may read several years’ worth of the letters that CEOs write to shareholders in their annual reports. Has the management team been consistent in its message, or is it constantly changing strategy or blaming outside forces for poor performance? If the latter, steer clear of the stock.

  18. As a general rule, most value-oriented portfolio managers won’t touch a stock with a P/E ratio above 30, even if it operates in a growing industry. (And why would they? Compared with the overall market’s valuation, that means the company’s returns would have to be roughly 50% better for investors to profit.) Remember, if you’re using “next year’s” or 2005’s projected earnings to calculate your ratio, you’re guessing–not evaluating. The next critical step is to review the cash flow statement, checking for positive (and hopefully growing) cash flow from operations. If a company has never managed to generate positive cash flow, any rise in stock price will be much more a reflection of wishful thinking than economic reality.

  20. There is no one “must have” stock, Make a pact with yourself here and now that you’ll hold off on your purchase at least until you’ve answered questions 1 through 9. If you invest on this basis, you’ll have the conviction to hold on to your stock throughout the broader market’s zigs and zags. You’ll also have the comfort of knowing that you have invested in, not gambled with, your long-term financial future.


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