For many people, it is boring to analyze the market and company finance. But if you can spend some time and energy on analyzing the market and company finance, you can greatly enhance your chance of making money in trading shares. Before you put your hard-earned money into the stock market, you should ask yourself these questions. In fact, these questions are pretty simple.
(1) How the company earn its money?
If you do not know what you are buying, it is hard to judge how much you should be paying. Therefore, you should know about the company you are buying the shares from. First you should try to understand how the company make its money before you buy their shares. Every investor should study the company’s recent annual report and financial statement. From the annual report’s income statement, you should find out the detail of the company’s business and each business’s sale volume and revenue. From these, you can find out the answer of the key question: Can these income be converted into cash? Although ‘net income’ and ‘earning per share’ are the benchmarks to judge the earning ability of the company, you should know that it is only an accounting concept. For shareholder, the most important thing is cash. No matter the profit is distributed to shareholders as dividend or reinvested into the company, the company need cash.
(2) Where is the profit come from?
Talking about cash, you should understand the key point: According to the generally accepted accounting principle, a company can account a sale as revenue long before the company can get the cash from the sale. That sale amount is put into account receivable. This can greatly influence the future share price of the company. Then how do you know whether the company has this kind of problem? Usually you can tell from the company’s income statement and balance sheet. But sometimes it is not easy to detect. You should be alert when a company’s revenue growth is much bigger than its competitors. If you cannot find what lead to the company’s big revenue growth, for instance, a product or service that particularly sell well, then you need to be careful.
(3) How is the company doing in comparison with its competitors?
Before you buy a company’s share, the first thing you need to know is the company’s sale data. You should ask yourself how much revenue the company can generate. This is the best clue to compare its position with its competitors. If the company is in a mature industry, you need to find out whether its sale volume is about the same or is growing. How about its competitors? If the company is in a high-growth industry, you need to compare its sale growth with its competitors. Comparing cost with its competitors is particularly important. General Motor and Ford has tremendous cost of personnel retirement and medical insurance expense that Toyoto and Honda do not have. That put General Motor and Ford in a disadvantageous position. General Motor finally succumb and lose the game.
(4) What economic condition has an effect on the company?
Some industry has strong cyclical variation. Company’s performance has a greater degree of dependence on the economic condition. For example, in economic downturn, the share price of a company in paper and forest product industry can become cheap. It is not necessary a good buy. It is cheap because of the economic condition. The sale volume drop as newspaper and magazine cut circulation because of decreasing advertisement income. Another big factor is interest rate. You should pay close attention. Interest rate change can have big effect on many industries.
The most important thing you have to consider before you buy your stock is to find out the degree of competition of the product or service price of the industry where the company belong. Price war can make the company’s profit decrease rapidly. In most industries, revenue lost from the price cut can hardly be offset by the revenue gained from sale increased. In most circumstances, the company who start a price war usually has an edge on cost.
(5) What will the company look like if something happen?
You have to figure out what can happen to the company if the worst comes to the worst. Ask yourself what the company will look like if that thing happen. For example, if a big part company’s sale volume come from a client, ask yourself what will be the company’s sale volume look like if the company lose the client. Usually you can find out this kind of information from the prospectus.
(6) What is the ability of the managing team of the company?
For the outsiders, it is usually hard to judge the ability of the managing team of the company. But you can take a look at and compare their annual reports in, maybe last five years. See if their communicating message is consistent or not? Do they blame outside cause for their mal-management? If they do, you should avoid that kind of company. Or if the company spend a lot of money on a new big beautiful headquarter building, you should not buy their share. There are a lot of company management out there who misuse shareholders’ money.
(7) What is the real value of the company’s stock?
For almost all the people, the real value of a stock is the profit that the stock can bring them. Some people buy a stock only if the stock is cheap. Some people buy a stock if many people are buying it. If you are one of them, you may not make any profit. If you buy a stock at high price, you may not make any money even you have picked the best valuable stock. If you buy a stock at low price, you may make money even you have picked a so-so stock. Then how do you pick a profitable stock?
Before you buy a company’s stock, you need to look at its price-earning ratio. It is the main criterion to evaluate the value of a stock. High P/E stocks (those with multiples over 20) are typically young, fast-growing companies. They are far riskier to buy than low P/E stocks. Low P/E stocks tend to be in low-growth or mature industries, in stock groups that have fallen out of favor, or in old established, blue-chip companies with long records of earning stability and regular dividends. In general, low P/E stocks have higher yields than high P/E stocks, which often pay no dividends at all. But on the other hand, high P/E stocks in fast growing or hot industries can have high earning growth which can drive the share price up quickly. In that case, you need to look at its earning growth. If its earning growth is greater than its price-earning ratio, it may still be a good buy. But remember that if you use the projected earning to calculate the price-earning ratio, you are not calculating but guessing. So make sure you are using a trailing P/E not the forward P/E.
The next thing you need to look at is the company’s cash flow statement. Cash flow statement analyze all the change that affect the cash account during an accounting period. When more cash comes in than goes out, we speak of a positive cash flow; the opposite is a negative cash flow. If the company’s cash flow is always negative, there may be some problem with the company. Companies with assets even well in excess of liabilities may nevertheless go bankrupt because they cannot generate enough cash to meet current obligations.
(8) Do I get what I am looking for?
If you are looking for capital appreciation and would like to see the share price increase quickly, you need to ask yourself this question. Are you picking a company that is growing fast? Find out its earning growth and earning per share growth calculated from the last three years or more. Companies with earning growth rate of more than 15% are considered fast-growing companies. Does the growth get the momentum? If the succeeding earning per share is greater than the previous earning per share, then it has the growth momentum. A company with growth momentum usually can cause its share price to go up. For example, a company whose earning per share are up 15% one year and 35% the next has earnings momentum and should see a gain in its share price. Check its share price record for the last three years or more. Do the share price record reflect the growth change. Read and analyze its quarterly report, annual report and other open announcement or news to see if they support its growing position. This kind of company usually is a young and aggressive company in a relatively new industries such as those in personal computer and internet technology sector during the last decade. These growth stocks usually can be found in NASDAQ.
If you are looking for current steady income, you need to check the dividend record of the company you are picking. Dividend record is published by Standard & Poor’s Corporation to provide information on corporate policies and payment histories. Do the company pay dividend steadily for the last three years. The amount of dividend is decided by the board of directors and is usually paid quarterly from the earning in the quarter they are incurred. So you may also check its earning record. Dividend can be paid in the form of money, share, scrip or, rarely, company products or property. Preferred stock has preference over common stock. That mean dividend must be paid to preferred stock first. Any left-over earning will then be distributed to the common stock. Amount of dividend is usually compared with other companies in yield called dividend yield. The dividend yield is determined by dividing the amount of the dividends per share by the current market price per share of the stock. For example, a stock paying a $1 dividend per year that sells for $10 a share has a 10% dividend yield. A 10% dividend yield or more is considered good and you won’t find too many of them. The dividend yield of stocks are listed in the stock table of most daily newspapers. Young companies usually reinvest their earning into their companies and do not pay dividend. Companies that pay dividend tend to be old and established, possibly are blue-chip companies. They are probably defensive stocks. You usually can find them in utility, food and beverage, healthcare and other low-growth or mature industries.
(9) Can I really keep the stock for long term?
Most of the time, if you buy your share based on what you hear from grapevine you cannot keep it for longer term. If you look into the company and can find the answer for the above questions, you usually can keep your share for longer term. This is value investing as Warren Buffet has called it. You are not buying the stock for speculation only. You are interested in longer-term profit. One more thing, be sure the company is in growing stage in a growing industry. If the company is already mature or is in a matured industry, the chance you get it for great capital appreciation is no good unless the company change course. If you are mainly looking for dividend income, that is a different story. You might keep the share for longer term but not for long term unless you are lucky to have a profitable company for long term which is hard to find.
