Value and growth investors seldom agree on what's important for evaluating a stock. But here are seven questions every investor, regardless of persuasion, should ask before plunking down money:
What does the company do?
Do you know what your company actually does for a living? Is it in a hot growth sector or in a saturated industry whose best growth days are long gone? Or does it make those proverbial buggy whips?
That first question is not as silly as it sounds. Sometimes we become so focused on analyzing the numbers that we forget about the big picture.
You probably know what the company does if you're looking at the likes of Wal-Mart Stores (WMT, news,msgs) or Google (GOOG, news, msgs). But it's a different story when you start examining at lesser-known names. For example, what do Icon (ICLR, news,msgs) and Knoll (KNL, news, msgs) do for a living?
You can find out in a New York minute by checking MSN Money's Company Report pages. Though only one paragraph, each report describes a company's products and/or services in pretty good detail, and it's written in understandable English.
The reports give you more than enough information to gain a feel for the company's products and/or services. For instance, Icon provides outsourced clinical-trial services to pharmaceutical companies, and Knoll makes office furniture.
What do you do with that wisdom? It depends. If you were looking for hot growth stocks, you would probably find Icon of interest but drop Knoll like a hot potato.
On the other hand, value investors, knowing that the market ignores unglamorous industries, seek out stocks such as Knoll in hopes of finding an undervalued gem.
How many widgets is it selling?
Companies are in business to sell products and/or services. We're talking big numbers here. Most publicly traded corporations rack up sales running into the hundreds of millions of dollars annually.
However, as an investor, you often encounter companies with a supposedly hot product on the drawing board but with little or no sales. When you buy such companies, you're buying the "story," which may or may not come to pass. That's risky business.
Risk-averse investors should stick with companies racking up at least $500 million in annual sales. Does that limit the field too much? Not really. When I checked recently, more than 1,700 U.S.-based stocks fit the bill.
More-adventurous investors can go lower, but the risk meter goes off the chart when you get below $100 million in 12 months of sales. At the very least, disqualify stocks with less than $10 million in sales in the most recent quarter.
You can find the past four quarters' figures (look for "last 12 months") on each Company Report page, and you'll spot the quarterly figures on the Highlights reportin the page's Financial Results section.
You can't apply minimum-sales criteria to banks and similar institutions, because their income comes from interest earned, which usually doesn't show up in the sales totals.
Just how profitable is the company?
For stocks, profitability means more than not losing money. Here's why.
Consider two hypothetical companies, company A and company B, both selling widgets for $100 each. After considering all expenses, company A makes $50 on each widget sold, while company B makes $25 per widget. If they both sell a million widgets a year, company A's profit totals $50 million compared with company B's $25 million.
Thus, each year, company A has $25 million more extra cash than company B. It can use that cash to develop new widgets, build more factories, pay dividends, etc. There is no way that company B can keep up with company A's spending without going outside to raise more cash, either by borrowing or by selling more shares. Both alternatives diminish shareholders' earnings.
Obviously, you'd be better off owning stock in company A than in company B, but how do you know which is which? That's where profitability measures come into play.
Return on equity, or ROE, the ratio of a company's 12-month net income to its shareholder equity (book value), is the most widely used profitability gauge. But relying on ROE has a downside. The way the math works, all else being equal, the higher the debt, the higher the ROE.
By contrast, you calculate return on assets, or ROA, by dividing net income by total assets, which includes liabilities. Consequently, all else being equal, the lower the debt, the higher the ROA.
You can see ROAs in the Investment Returns section of the Key Ratios report (under Financial Results). Look for companies with ROAs above 10%. Avoid ROAs below 5%.
Growth investors should pay most attention to the trailing-12-months ROA. However, because value stock candidates may have recently stumbled, value investors should focus on the five-year-average profitability figures.
Is cash flowing in or out?
Cash flow measures the amount of money that moved into or out of a company's bank accounts during a reporting period.
Cash flow is a better profit measure than earnings because it's harder to finagle bank balances than numbers like depreciation schedules that figure into earnings. In fact, many companies that report positive earnings are actually losing money when you count the cash.
Operating cash flow measures the cash flow attributable to the company's main business. You can find it on either the quarterly or annual cash flow statement (see Statements under Financial Results). However, the quarterly statements are timelier. That said, be aware that the quarterly cash flow columns reflect the year-to-date (cumulative) totals, not the individual quarters' results.
You want companies with cash flowing in, not out. So look for positive numbers in the Net Cash from Operating Activities row. Though any positive number is OK, it's best if the operating cash flow exceeds the net income (top line) for the same period.
Is the company submerged in debt?
High debt is not always a bad thing. For instance, there's nothing wrong with a company borrowing at 6% if it can put the funds to work earning 12%. Nevertheless, the higher the debt, the more susceptible a company is to rising interest rates. Rising rates result in higher debt-service costs, which subtract from earnings.
The financial leverage ratio (total assets divided by shareholders' equity) is an all-purpose debt gauge. A company with no debt would have a financial leverage ratio of 1, and the higher the ratio, the more debt.
As a rule of thumb, avoid companies with leverage ratios above 5, which is the average of S&P 500 Index($INX) stocks, and lower is better.
You can't apply the leverage ratio -- or any other debt measure, for that matter -- to banks or other financial organizations. For them, borrowed cash is their inventory. Financial companies always carry high debt compared with companies in other industries.
Any bad news lately?
Negative news, such as an earnings shortfall, problems with a new product or an accounting restatement, not only pressure a company's share price but often portend even more such news on the way.
Bad news is the death knell for growth stocks, and growth investors should avoid all such stocks.
Even value types, who seek out stocks beaten down by bad news, should wait on the sidelines until they're reasonably sure that there is no more to come.
Think months, not weeks.
Take a look at the company's latest doings by selectingRecent News at the left of a stock's quote page.
Which way are forecasts moving?
There is much to be gained by paying attention to analysts' earnings forecasts.
MSN Money displays consensus earnings forecasts for most stocks. These are the average forecasts from all analysts covering a stock. The consensus numbers tend to move in trends. Why? I'm not sure. One reason may be that after one analyst makes a significant change, others re-examine their models and then revise their estimates in the same direction.
Changes in consensus earnings forecasts move stock prices. A positive forecast trend moves prices up and vice versa.
You can use the Consensus EPS Trend report (under Earnings Estimates) to see current, next-quarter and fiscal-year estimates going back 90 days. Focus on the fiscal-year data and ignore 1-cent changes. Avoid negatively trending stocks -- that is, stocks for which the latest fiscal-year estimates are more than 2 cents below the figures of 90 days ago.
Answering these seven questions will help you make better investing decisions, but they are just a start. Dig deeply and learn all you can. The more you know about your stocks, the better your results.
At the time of publication, Harry Domash owned or controlled shares of the following company mentioned in this column: Icon.
Published Oct. 14, 2008
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