Five Questions To Ask Yourself Before Buying A Stock

>base into a dollar of profits. A company with a
If you are like most people today, you havereturn on assets of 20%, for example, has
either thought about investing in the stock marketproduced $0.20 of earnings from each dollar of
or you actually went out and bought some stock.assets. Similarly, return on equity measures how
If so that’s great, there is lots of moneywell the firm has turned a dollar of shareholders
to be made in the stock market, but theequity into earnings.
important question is; How do you pick yourMeasures like return on equity and return on
stocks?assets help you understand how efficiently a
Are you buying the stock, because your brothercompany allocates its resources, and they allow
told you to?you to look beyond raw profit numbers.
Did you get a hot tip from your mailman?Companies with the same earnings figures might
Or are you just buying the stock because youhave very different returns on equity and returns
like the company’s products?on assets, depending on how well they have
Believe it or not, a very large percent of peopleturned their assets into profits.
who invest in the stock market are investing their4. How Healthy Are Its Finances?
hard earned money based on the aboveEarnings and cash flow are two different things.
examples without any further research.You could earn a very generous salary but still run
Does this sound like a smart way to invest tointo cash-flow problems if you get paid only twice
you? It certainly doesn’t to me.a year. Because of quirks in accounting practices,
Now if you ask your brother what stock to buya company’s reported earnings often differ
and your brother happens to be Warren Buffett,from the amount of cash it brings in the door.
well then I think its safe to say you will make aThe statement of cash flows, which is part of the
good investment, but how many of us can claimannual report, will tell you just how much of the
Warren Buffett as our brother?money a company pocketed.
For the vast majority of us this kind of investingIt’s also important to see how the
is very risky, while you could make money, it iscompany uses that cash. Digging into the cash
more probable that you will lose money.flow statement to find out where the
To help you keep from losing your money and tomoney’s going can shed light on
help you make the best choice when pickingmanagement’s strategy and give you
stocks, below you will find the five mostadditional insight into the company’s future.
important questions to ask yourself before buyingIs it building aggressively for the future by opening
a stock.new stores or building new manufacturing
1. What Does the Company Do?facilities? Is it buying other firms, paying off debt,
This sounds like pretty basic information, but itbuilding up cash reserves, buying back stock, or
can be tough to find. Most companies offer morepaying dividends?
than one product; a big conglomerate might offerCompanies can also issue debt to finance new
hundreds of different products in a range ofplants and research efforts or to bail itself out of
industries. Digging into the company’s lineupshort term cash problems. Companies need to
can give you a better sense of the forces thatwatch their debt levels, though. Too much
will drive its results.borrowing can force the company to use its cash
Scrutinizing a company’s product line cansto pay interest, instead of applying it to more
also tell you where its profits come from. Forproductive ends.
example: video games accounted for 11% ofNo hard-and-fast rule will tell you how much debt
Sony’s SNE total sales in 2000 but 40% ofis appropriate for a particular company, because
its earnings.levels of indebtedness can vary across industries.
The annual report is the best source for this kindTo get an idea of whether a company is
of information. Be sure to read the shareholdersoverburdened by debt, divide its assets by its
letter, as well as the presentations of theequity. The result is the company’s financial
company’s product lines. Those are alsoleverage.
part of the company’s SEC filings.5. Is It Worth the Price?
2. How Fast is the Company GrowingA company might clear all these hurdles, but sell
Over long periods of time, stock prices are drivenat too high a price to be an attractive investment.
by earnings growth. That can come when aIt all depends on how much its prospects are
company cuts costs, but ultimately, revenuesworth.
have to increase if earnings are to keep going up.To figure that out, look at its forward Price
If revenues, also called sales, are increasing,earnings ratio, for example General Electric has a
that’s a good indication that something isforward P/E of 41, which means that the
working. Maybe the company boasts ashareholders now pay $41 for $1 of the
better-than-average product or a more effectivecompany’s future earnings.
sales force. In contrast, flagging sales can signalAnother widely used measure is the price/book
trouble.ratio. That shows how much shareholders are
Earnings growth signifies that the company ispaying for $1 of the company’s assets.
making more that enough to offset its costs.Whichever ratio you use, compare it with its
Established companies should show consistentparallels for other companies in its industry and
results, but young companies often display strongfor the market as a whole. That will tell you how
revenue growth with little or no earnings. Witnessexpensive the stock is, relatively speaking.
the myriad of Internet companies with lots ofRemember, stocks with very high P/E and P/B
sales and no profits.ratios can fall dramatically when any little thing
3. How Profitable Is It?goes wrong.
In addition to growth, look at how efficiently theAnalyzing stocks isn’t easy, but you will be
company makes money. Return on assets showsoff to a solid start if you ask these questions first
how well it has translated a dollar of its assetbefore buying a stock.