Ten Questions That You Should Ask Prior to Purchasing a Stock
The first thing that you should understand is how the company earns money. Just because everyone else is buying the stock and the price has run up tremendously does not mean that you should also be jumping on the band wagon.
1. How does the company make money?
The first thing that you should understand is how the company earns money. Just because everyone else is buying the stock and the price has run up tremendously does not mean that you should also be jumping on the band wagon. I suggest that you review the annual report to see the statement of cash flow. Are net earnings increasing while cash is declining? This could be a warning sign that the company could be manipulating the net income. Every company earns money differently. If you don’t review the financial reports you may not understand the industry that the company is operating in. For example, when you hear the name General Motors you may immediately conclude that their earnings are tied to the auto industry. However, a closer examination of their financial report will reveal that over 50% of the company profits come from GMAC financing. This wholly owned subsidiary earns money by lending in the financial markets. Therefore, the earnings of GM are tied more closely to the banking industry.
2. Are the sales real?
The next area that you should review is the revenue growth of the company. A company can book revenues long before the cash comes through the door. Sometimes companies will employee creative accounting methods to accelerate revenue bookings. A warning sign of company sales not being real can be found by looking at the aging of receivables. If the time to collect the company receivables is growing there may be a problem with the sales not actually becoming collectible.
Also, look at the financial statements to determine is the company has a concentration of risk in selling product to a few large customers. If this is the case, beware that there could be instability in the future growth of the company sales. You should compare sales growth of the revenue to the industry average for competitors. If the company is growing at a faster rate than its competitors you should try to evaluate the reason for this.
If you can’t pin down a reason to a specific product or event you have a right to be suspicious.
Be careful of companies that are increasing sales through acquisitions. This may look good to Wall Street Analysts. However, if the sole source of revenue growth comes from acquiring other companies this may be a warning sign that the business model of the company is unstable. Acquiring a number of companies can spell disaster for the long run and involve costly reorganization expenses to clean up the books.
3. How is the company doing relative to its competitors?
Compare the company sales to the revenue growth in the same industry. You should also review the growth of the industry as a whole. For example, if you are looking in the golf industry and find that one company is growing at the expense of another competitor’s lost sales, you should be careful. The lack of industry growth could be of sign of instability in the future for that particular industry. Pay close attention to the change in market models. For example, K Mart in the 1970’s had an excellent business growth rate, however, they were surpassed by Wal Mart in the 1980’s that had a more superior distribution channel and pricing structure. The lesson learned here is that you can not stand still and that you need to be aware when management fails to keep up with the competitor.
4. How does the broader economy affect things?
We live in a world in which the political and international climates are ever so important to keep in mind. In the US, you should pay attention to factors that can affect the liquidity of the markets. For example, lower interest rates allow for cheaper financings costs for companies. Likewise, a tax reduction will also free up additional company resources to spend on other areas. However, if the current political climate is distressed, you should be careful with the types of industries you choose. For example, in California they recently suffered a set back in running a $15 billion dollar deficit. California is out of money and will look to its citizens and businesses to make up the difference. A recent passing of the $14 billion bond initiative by the California voters should put some liquidity back in the markets. However, it will not solve the problem as to how the deficit was created. When looking at companies to invest in, you should pay attention to the political climate and factor that make it easy for a company to grow.
5. What could really hurt—or even kill – the company over the next few years?
What are the inherent risks associated with the company growth. For example, is the company a one product company. Is the company investing heavily into research and development to diversify its product lines? It is hard for a company with new technology to stay on top for a sustained period of time. In today’s world companies should have depth and diverse markets to capture market share and develop customer loyalty.
6. Is management sweeping expenses under the carpet?
If a company is announcing “one time restructuring charges” be aware of what is happening. This is another way of saying, management made some poor choices and they are trying to clean up the books. If these charges are made year after year, it could be a sign of a failing business model. You should read the financial statement footnotes to understand the nature of the charges.
7. Is the company living within its means?
There are two types of managers in this world: spenders and accumulators. When you look at the company financial statements what do you see? Is the company living within its means. If you see the company trying to accelerate growth through debt: be cautious. That debt will need to be repaid someday. If the company does not grow as expected, the stock value will be the first to drop.
8. Who is running the show?
What type of track record does the current company CEO have. Who is running the show? You should investigate the management style of the person in charge to determine their track record. Usually, a great CEO will have continued success regardless of the company they are involved with.
9. What is the company really worth?
There is a saying, “If it is too good to be true, it probably is”. If a stock is continuing to hit 52 week highs week after week. Find out why? Just because the stock has run up in value does not mean that it is a great buy. Don’t follow the herd. You should look at the fundamentals of the company and be patient. Look at the stock Price/Earnings ratio. You should also look at the P/E ration with the forecasted earnings for the next year. If the company has a P/E ratio over 30, I wouldn’t touch it. In today’s market, cash flow is king. Still with companies that show a strong cash flow and that manage their costs well. A company that shows sustained dividend increases is sending the message that they care about the shareholders and that the company is cash strong.
10. Do I really need to own this stock?
Can you afford to lose the money you are risking when you purchase the stock. If the answer is no, then don’t make the purchase. The way to make great returns in the market is by investing in great companies and then holding the stock for the long term. You should purchase the stock and then forget about it. If you find yourself consistently looking up the stock price each day or week, you probably have too much invested. You need to have the conviction to hold the stock in the up and downs of the market. Investing in companies that can withstand the storms or market turbulence will give you a greater peace of mind in your long-term financial future.
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ABOUT THE AUTHOR
Alan L. Olsen is the managing partner at Greenstein Rogoff Olsen & Co., a top Bay Area CPA firm. A specialist in income tax planning, he frequently lectures and writes tax planning articles for professional organizations and community groups. Trusted Advisors to the Highly Successful.