There are thousands of stocks to choose from in the stock market, although most of these companies are not worth investing in. The majority of companies are not able to consistently grow earnings in todayâs competitive marketplace. Even worse many companies do not have the shareholders interest at heart. Management often have their own agenda.
To pick the right stock you need to do your due diligence. Since you will be giving your hard earned money in exchange for small pieces of ownership you want to make sure that the company you invest in deserves your capital. There are three areas of a company that needs to be analyzed before you invest your money. First review the companyâs financials and make sure that they are sound. Second, review their management. Third, make sure you pay a fair price for your investment.
Financial Soundness
You need to become very familiar with two documents, the Income statement and the Balance sheet. These documents can be found on the companyâs website or on other financial sites like,
Reuters and Google Finance. First I like to look at the income statement and see if the company is working on a thin margin or if they have room for error.Divide Net Income with total revenue (Net Income / Revenue). That will give you the net profit margin. Look at annual data, not quarterly data. It will give you the bigger picture. I also like to look at the data for the past 5 years to make sure that they have a consistent record.
The net profit margins are different among industries but as a general rule I like to invest in a company that has at least a net profit margin of 10%. That will give you some assurance that the company will survive hard times and unforeseen circumstances.
Next I want look that the companyâs balance sheet. I want to make sure they have a manageable amount of debt. Too high debt leads to slow future growth and potential bankruptcy.
There are many different ratios to look at but I prefer Warren Buffettâs method for analyzing debt since different companyâs can handle different amount of debts.
Look at total debt and calculate how long it would take for the company to pay back all its debt using its current net income. If it takes longer than 5 years the company has too much debt.
Next look at the return on equity (ROE) for the past 5 years or more, this will give you an idea how much income the company has been able to generate with shareholders invested capital. The average company has about a 10% return on equity so a smart investor should look for more than that. Also, a higher return on equity means that the surplus funds can be used to improve and expand operations. This means that there is less of a need to borrow.
It pays to do the homework. Did you know that you will do more research than 98% of investors if you read a companyâs annual report. You will do more research then 99% of investors if you read the foot notes. I donât know about you but I certainly like to have an edge above 99% of other investors. You can download any publically traded companyâs annual report at the security and exchange commission.
Jim Rogers take on researching annual reportsâ¦
"The best advice I ever got was on an airplane. It was in my early days on Wall Street. I was flying to Chicago, and I sat next to an older guy. Anyway, I remember him as being an old guy, which means he may have been 40. He told me to read everything. If you get interested in a company and you read the annual report, he said, you will have done more than 98% of the people on Wall Street. And if you read the footnotes in the annual report you will have done more than 100% of the people on Wall Street. I realized right away that if I just literally read a company's annual report and the notes -- or better yet, two or three years of reports -- that I would know much more than others. Professional investors used to sort of be dazzled. Everyone seemed to think I was smart. I later realized that I had to do more than just that. I learned that I had to read the annual reports of those I am investing in and their competitors' annual reports, the trade journals, and everything that I could get my hands on. But I realized that most people don't bother even doing the basic homework. And if I did even more, I'd be so far ahead that I'd probably be able to find successful investments."
Management
Like it or not management makes a big difference whether a company will be successful or not. Researching a companyâs management is not an exact science but smart investors can finds hints and clues by looking at past results.
Finding a successful management team takes some work. But remember once you have found a great team they will be working for you! Do not hold back on this important research exercise. Start with the annual report. Here are some general ideas of what to look forâ¦
Look for mangers that have the companyâs best at heart with a long history at the company or a solid track record at another company. A good sign is if they have large ownership stake in the company. Avoid managers who enrich themselves at the expense of the company with extravagant salaries and abuse share option arrangements.
Managers that cut corners and try to boost the short term earnings at the expense of the companyâs long term viability should be avoided. A sign of this practice can be seen among manager that issue valuable shares or use debt to buy overvalued assets. They pursue growth for growthâs sake regardless of the value of the growth.
Good Practices among managersâ¦
Buy back for shares when it is within the companyâs interest. If the company has excess capital and the current market stock price is below its intrinsic value it is a good practice to buy back shares.
Look for managers that have track record of growing earnings and generating a high return on equity (ROE) over time without going into debt to do so.
Manager that manage debt conservatively and use organic cash flow to grow the business.
Managers that have ability to allocate capital. When a company sticks to its core competence they usually have the best results show. Managers are asking for trouble when they wander off and spend the shareholders money on exotic ventures they know very little about.
Buy stocks at bargain prices
One thing you want to avoid is to pick the right stock after hours upon hours of research and then not make any money because you overpaid for the stock. The initial research is important but before you decide to invest you must you make sure you pay a fair price. Or like Warren Buffet says "Never count on making a good sale. Have the purchase price be so attractive that even a mediocre sale gives good results."
Try to shift your thinking and look for bargains deals instead to looking at the latest and hottest stock. The hottest stocks are usually overvalued. Consider shopping for stocks the same way you would shop for groceries or everyday items. You look for things that are on sale right? At least I do! If one brand of orange juice is on sale I buy it. If they have a two for one special I will pick up extra for next week. You get the picture I hope.
First, a common mistake made by novice investors is to look at the price of the stock and determine if itâs cheap or not. The price of the stock itself has nothing with the value of the company. A $100 stock can be cheaper than a $1 stock. The value of the company has to do with its total assets and what they are expected to earn tomorrow.
Here are some different strategies for valuing a stockâ¦
Look the P/E ratio. The price to earnings ratio (also known as earnings multiple) tells you how much you are paying for the companyâs current earnings. The higher the P/E ratio the more you are paying for earnings. A high P/E ratio indicates that the company is expected to grow at a higher rate and that you will pay a premium for those higher earnings. It can also mean that the company is overvalued. If it seems unlikely that the company will continue to grow at the estimated rate itâs probably overvalued.
If you are comparing two companies in the same industry with identical balance sheets and income statements and one of the two happens to have a lower P/E ratio you have an idea of which company is cheaper. Companies in different industries trade at different P/E ratios. If you want to do a comparison of the price you will get more accurate results if you measure P/E ratios within the same industry.
Price/Earnings to Growth (PEG). Formula: P/E Ratio / Annual EPS Growth. PEG is used by many value investors to value companies. A lower PEG ratio means that you are paying less for future earnings growth. A bargain stock typically has a PEG below one. Keep in mind that the PEG is only as good as the forecasted earnings. If the earnings growth is wrong the formula will be wrong.
Price to Book Ratio (P/B Ratio). Formula (Share outstanding x stock price) / (Tangible assets â Intangible assets â liabilities). A low P/B Ratio might mean that the company is undervalued. It is good tool for comparing two companies.