Sunday, October 09, 2011

How To Effectively Investigate A Stock

Thanks to the internet, there is an information overload when it comes to investigating stocks. Simply type in a ticker symbol in any search box, and within seconds you have dozens of articles and related links on that particular stock. Properly navigating through the haystack of information and determining how to use it can be daunting and intimidating, and while there are no shortcuts to properly evaluating a stock, investors can eliminate a lot of unnecessary or repetitive effort by knowing how to effectively investigate a company.

TUTORIAL: Investing 101 For Beginner Investors

Basics First: What is a Stock?
As elementary as it sounds, many investors know what a share of stock is, but often ignore what it means. Stock is an equity claim on the business. Specifically, owning stock is defined as having a residual claim on the business. A stock investor's claim on a company is residual by debt holders and preferred stock holders.

Balance Sheet
Because of this residual claim, the very first place investors should go when investigating a stock is the balance sheet. The balance sheet is one of three principal financial statements of any company, with the other two being the income statement and the statement of cash flows. The balance sheet gives a snapshot of the company's financial position at a specific moment in time. As such, it is more important than the income statement. (For more information, see 5 Tips For Reading A Balance Sheet.)

Often, investors first examine the income statement in order to determine profitability. Profits are extremely valuable, but the balance sheet shows you how healthy a company is. A profitable unhealthy company is a disaster that many investors fail to consider. A quality balance sheet protects a company when times get bad. Consider the various recessions in the U.S. in the past 50 years; most of the companies that failed to make it through had a balance sheet problem.

When looking at the balance sheet, you want to examine the indebtedness of a company. Evaluate the debt in relation to total assets and equity value. Consider the quality of the company's assets. How do current assets stack up against current liabilities? How much cash is on the balance sheet in relation to debt? How much goodwill or other intangible assets are on the balance sheet? Under tough operating environments, goodwill and intangibles are usually worth very little for most companies.

Once a balance sheet has been examined, it can be connected with the other financial statements. Look at the interest expense line item on the income statement and compare it to the company's earnings before interest and taxes. Is the company comfortably making its interest payments?

Once you get a handle on the financials, investigate management. An effective way to do this is by reading a company's annual proxy statement (DEF 14A), which can be found on the company's website or at the Securities and Exchange Commission website. A proxy statement will show you insider ownership levels and management pay, two good metrics for evaluating management. (For related reading, see SEC Filings: Forms You Need to Know.)

Investigate Industry
If you are still comfortable with the company, it's time to investigate the industry. One quick way to do this is to compare numbers between competitors. Some great numbers to investigate:

1. Operating Margins
Does one company have significantly higher or lower margins than the others? Is this a long-term occurrence or a one-time benefit?

2. Debt to Equity Levels
Is the industry characterized by high or low levels of debt? How does the company stack up?

3. Capital Expenditures
Found on the cash flow statements. Is the industry capital intensive? If so, this could be a problem during weak environments.

4. Competition
Is there a lot of competition? Coca-Cola only competes with a couple of companies. Teen retailer Abercrombie and Fitch has lots of competition. A great deal of competition can make it difficult for a company to consistently earn profits, as these businesses have to compete on price.

Detective Work
Once you have done all the above, the detailed detective work begins. Now you should go back and read the company's financial releases and get a feel for the how the company is looking at growing and creating value for the business. Examine the company's additional SEC Filing, including 13D filings which show if other major investors are taking stakes in the company.

If the particular company you are looking at has operations in your area, go visit them. Some of the best analysis on a company is not found in documents, but visible through the day to day operations.

In the end, this investigative work will give you your unbiased insight into the company. As a result, you are far more likely to make better investment decisions based on quality data and analysis. (For related reading, also take a look at Blending Technical And Fundamental Analysis.)

by Sham Gad (Contact Author | Biography)

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