Investing in the Stock Market

There was a time when selecting a successful stock was a piece of cake. All a person had to do was to find the market's hottest sectors, buy a stock from that group, then sit back and watch the profits roll in. No one needed to do any research or think about the long term potential of a stock. Times have changed and investing strategies need to follow suit. It is important to research companies and find out which ones can product over long time periods. To help you uncover those winners, there are five simple questions you need to ask.

What does the company do?
Though this may seem like basic information, it can be a daunting task to complete. Nowadays companies offer more than one product. Big conglomerates, like Proctor & Gamble, offer hundreds of different products in a variety of industries. By understanding each of their various branches, the better grasp you will have of their companies' direction.

By researching a company's product line, you can tell where its profits come from. Their annual report is the best source for this information. Check the company's SEC filings for additional information, like the shareholder letter or the presentation of the company's product lines.

How quickly is the company growing?
A company's stock price is driven by earnings growth over the length of time. Occasionally earnings can occur when cuts are made, but in the end, increased revenues have to increase if earnings are to keep escalating. A good sign of a company is when they are increasing their revenues. When a company has 'flagging sales', it could be a sign of trouble for the future. Earnings growth says the company is making more than enough to combat their cost of operation. Well established companies need to show consistent results. Younger companies tend to display strong revenue growth with little or no earnings.

How profitable is the company?
You need to look at how efficiently a company makes money. A key indicator is the company's return on assets and equity. These measures will help you understand how efficiently a company allocates their resources. By looking past the raw numbers, you will have a better understanding of the company's financial backbone. Companies can report the same earning figures and have very different return on equity and assets, depending on how they turn their assets into profits.

Return on assets measures how well a company changes a dollar of it's assets into a dollar of profits. While return on equity looks at how the company converts a dollar of their shareholder's equity into earnings.

Is the company financially healthy?
Remember earnings and cash flow is two different things. Simply put, you can earn a very generous salary but will have the chance of experiencing cash floor problems if you are paid two or four times per year. A company's report earnings will often differ from the amount of cash it brings in. When you examine a company's annual report, pay attention to the statement of cash flows since it will show you how much money the company has placed in its accounts.

As an investor, it is important to see how the company uses their cash. You should be able to accomplish this by delving into the cash flow statement. You will be able to gain some insight into the management's strategy and the future of the company. Is the company spending money on globalization or focusing on a new brand of product? A red flag should go up when you see the company borrowing too much because it could force them to use their cash to pay the interest rather than using it more productively.

There is no hard fast rule to tell you how much debt a company should have, because the amount can vary based on the industry. If you divide the company's assets by its equity, you will uncover their financial leverage. The company's financial leverage is a good tool to see if the company has too much debt. You can compare this number with others in the industry to see where they rank.

Is the company worth the price?
Even if all of the previous questions have been answered correctly, the price could be too high to make the company an attractive investment. To help determine what price is too high, take a look at the forward price earnings ratio. If a company has a forward p/e ratio of 32, this would mean the shareholders pay $32 for $ 1 of the company's future earnings.

Once you know the ratio, compare it for parallels with the other companies in the industries and for the market as a whole. Never forget, stocks with a very high p/e ratio can fall dramatically when even the littlest thing goes sour.

Analyzing stocks is not easy, but if you spend the time to answer the questions, you will be headed in the right direction to making an informed decision.