Surveys conducted during the stock market frenzy of the late 1990s showed that the average investor would put a lot of effort into researching where to go on holiday, but skimped on the time spent researching stocks to buy. Sounds really sloppy, doesn't it? But it is indeed a familiar and common practice. To be honest, for most people it's much easier to flick through a travel guide and find a beachfront hotel in Antigua than to understand something as complex as a public company. People would rather roll the dice to decide which stock to buy.
But here's the incredible thing: With a little time and effort, investors can avoid the cycle of "Pure luck" When it comes to investing. To make it easier to understand, we have put together a list of 10 basic questions that every investor should ask before putting their hard-earned money into a particular stock. Inspired by corporate advisers like ram Charen, this approach does not require you to go through the hassle of financial stock analysis. In fact, some of the questions may sound superficial. But we can assure you that if you do ask these questions before you buy a stock, you are making a solid bet on the long-term prospects of a company, not just taking your chances.
1, How will this company make money?
If you don't know what you're buying, it's hard to judge how much to pay. Therefore, before you buy a stock, you should find out how the company makes money. This may sound like a simple question, but the answer is not always so clear-cut. For example, General Motors sells tens of millions of cars every year, but unfortunately the company makes little to no money on them. In fact, almost all of gm's profits now come from loans to consumers through the company's finance subsidiary, General Motors financial services. And as you might guess, profits from auto loans only account for half of the total, with the rest coming from home mortgage loans issued through gm subsidiaries like ditech.com (the same business whose tv ads are ubiquitous). This doesn't necessarily mean that gm's stock is bad. But it clearly gives you a better idea of the risks and potential profits of this company.
Scan through the profiles of fortune 500 companies and you'll see dozens of examples of this. This is why every investor must look at the company's latest annual report. You can get a detailed picture of the company's business composition and a breakdown of sales and revenue figures for each business in the annual report. You can also find the answer to another key question: Are these earnings likely to be transferred to cash in the hands of investors? While things like 'net income' and 'earnings per share' make headlines in the business press, they are merely accounting concepts. What matters to shareholders is real, hard cash, whether that cash is distributed to shareholders in the form of dividends or reinvested in the company's operations, thereby driving up its share price. Look at the cash flow statement in the annual report and see whether the company's "Cash flow from operations" Is positive or negative, and whether it is increasing or decreasing. Look for red flags that net profit (as shown in the income statement) is increasing while cash flow is decreasing. If this is the case, it may be a sign that the company has used "Creative" Accounting techniques to inflate its book profit, which is not beneficial to shareholders. Enron is an example of this.
2, Are sales real?
When it comes to cash, one of the main points to understand is that, according to accounting rules, a company can include a cash payment in sales revenue long before it actually arrives (in the worst-case scenario, the cash never arrives). This could significantly affect the current price of the shares you intend to buy. So how do you know if the company has done something like this? This can usually be seen quite clearly from the earnings reports filed by the company. Take the technology company RSA security as an example. In the notes to its first quarter 2001 financial report, the company discloses that it has switched to a more aggressive (but legal) accounting method of including software in sales revenue as soon as it is sent to resellers - why wait until the end user actually buys the product before accounting for it?
Sometimes such warning signs of revenue manipulation are more subtle. Be wary, for example, of companies whose sales revenue is growing at a much faster rate than that of their competitors. If you don't see a specific reason for the company's sales growth, such as a product that is selling particularly well, then you need to be more careful," says court accountant jack Michalski, publisher of the authoritative analysts' accounting monitor. Also beware of companies whose only way to achieve sales growth is to gobble up other companies. If a company is acquiring several companies on average each year, the motivation may be management's desire to meet wall street's short-term expectations. In the long run, however, consolidating several separate companies together can be messy and costly.
3, How well is the company doing compared to its competitors?
Before buying a company's stock, it is vital to understand how it has built up its competitive strength. The easiest way to start is to analyses the company's sales figures. The best clue as to whether a company is better than its competitors is to look at the company's annual revenues," says mutual fund manager Ron Mir encamp. The fund that bears his name has consistently outperformed the S&P 500 over the past 10 years. If the company is in a high-growth industry (e.g., Video games), how does its sales growth compare to that of its competitors? If the company is in a mature industry (e.g., Retail), have sales remained flat or increased over the past few years? Pay particular attention to the sales performance of new competitors, especially in industries that have stopped growing. Walmart's entry into retail has been frustrating for all in the industry," says minicamp. In the past, people thought Kroger and Safeway were cheap enough, but there was no Walmart competing with them back then."
When comparing the company to its competitors, don't forget to compare costs. Take car manufacturers General Motors and ford, for example, both of which carry heavy burdens such as pensions and health insurance for retirees, expenses that put them at a significant disadvantage against foreign rivals such as Toyota and Honda.
4,How does the general economic environment affect companies?
Some stocks are highly cyclical - in other words, the performance of the company depends heavily on the overall economic conditions. Cyclically volatile stocks sometimes appear to be inexpensive, but they are not. For example, in an economic downturn, shares in paper companies can become very cheap. But there's a big reason for this: The recession has reduced advertising spending by many companies, newspapers and magazines have fewer page numbers, and so paper companies sell less. Of course, when the economy comes out of the doldrums, things go in the other direction again.
Investors should keep a close eye on the movement of interest rates, as changes in interest rates can have a huge impact on many industries. For example, interest rates have fallen sharply over the past two years, which has led to a sharp increase in home refinancing and consumer spending. This has been extremely positive for industries such as homebuilders, appliance manufacturers and retailers. However, it is unlikely that interest rates will continue to fall and most economists also expect that interest rates are likely to rise in 2004. So, the growth of those companies that have benefited from lower interest rates could slow down significantly.
Perhaps the single most important factor to consider before buying shares is the degree of price competition in the industry in which the company operates. Price wars may be greatly beneficial to consumers, but they can quickly reduce a company's profits. An analysis of fortune's 1,000 largest companies by the consulting firm McKinney & company shows that for every 5 per cent drop in the selling price of a product for a company, sales would have to increase by 18 per cent for the company to maintain its original profits. Craig Zawada, a pricing expert and partner at McKinney & company, warns that "Most industries can't increase sales by that much". In most cases, companies that wage price wars need to have a significant cost advantage over their competitors to ensure profitability. Just look at the ongoing profit disasters for McDonald’s and burger king as a result of the so-called "Burger wars".
5, What factors could damage or even destroy a company in the coming years?
Before investing in a company, you must consider the worst possible scenario for the company in the future. If, for example, a large proportion of a company's sales come from a particular customer, then if the company loses that customer, sales could be significantly reduced. You can get an idea of these risks by looking at the company's IPO prospectus (if the company has just gone public) or the company's latest 10-k annual report filed with the sec. If you look at sycamore networks, the fiber optic manufacturer that went public in late 1999, anyone who read the company's prospectus will see that the company had only one customer - Williams’s communications. Sycamore's share price has now fallen 97% from its 2000 high.
