Everywhere you read about stocks you always see the expression “due diligence.” What does that really mean, and how do you effectively do it? Simply stated doing proper “due diligence” means to use prudence and responsibility in researching a stock that is under consideration. It involves becoming familiar with that company’s operation, its management, and relevant fundamental facts related to company growth, profit and loss, business cycle, and how it rates among its peers. Fortunately, there is a great deal of readily available information regarding every publicly traded equity, and there are a number of simple ratios and other factors that make evaluating a stock, and comparing it to others in its field, a relatively straightforward process.
First of all every company traded on a public exchange publishes quarterly and annual reports which provide detailed information regarding historical background including: revenue, income, debt, risk factors, etc. Additionally, these documents are generally published with an explanatory commentary from the Chief Executive Officer, the Chairman, or President that puts the information in context and explains current management perspective. All of this information, however, is being published by the company whose goal is to put everything in the best light possible. It is important, therefore, to go beyond the verbiage, and evaluate the numbers.
Fortunately, for the everyday investor, it is not necessary to dig deeply into company published profit and loss statements to find the fundamental numbers required to do an evaluation, this has been done for you by a great number of free financial websites including Yahoo Finance, Google Finance, and MSN Money, to name a few of the larger ones. I am not suggesting that delving into financial statements and becoming totally familiar with every financial aspect of a perspective stock purchase is a bad idea, I’m simply saying that it is not necessary to obtain the basic information required to make an informed decision. It is my opinion, that once you have a good understanding of what it is that a company makes, or what service it provides, then there are roughly ten metrics that you can use to compare it with its peers, and to determine if it is a stock that you want to purchase.
Revenue is perhaps the most important metric. Without revenue a company cannot survive. Generally by gaining an historical knowledge of what the revenue trend is, one can determine where a company is in its growth cycle. Like us, companies tend to have rapid growth in their early years, slow in maturity and stop growing and even shrink toward the end of their life cycle. Where a company is in its growth cycle is very relevant to you as you are making your investment plans which are also in part determined by where you are in your life path.
While companies can exist for long periods with little or no earnings, it is only under very unusual circumstances that one would want to buy into a company that is not generating income, or doesn’t appear to have the opportunity to generate income in the very near future. Whether income is growing or declining is easily determined by historical data. The simple ratio of current share price to earnings (PE ratio) compared to historical PEs and also compared to the PEs of other companies in the same field will provide a quick indication of whether a stock is priced appropriately, too high, or too low. As a buyer you want to find a stock that has an irrationally low PE compared with its peers. This often happens when the market overall takes a significant drop, or when the sector drops due to some factor that is irrelevant to the stock in question. Care must be taken to be sure that the low PE isn’t because the company is in trouble and the stock price is dropping due to an anticipated drop in earnings.
Earnings per share (EPS)is also readily available information on just about every financial website, and specifies how much of the corporate earnings can be allocated to each share. This is important when looking at dividends, for example, to determine how much of the available funds are being paid out in dividends and how much is left over for company growth, dealing with unexpected problems, etc. If EPS is negative, or if dividends equal or exceed earnings, it obviously is a red flag and means that something is amiss, or there are special circumstances that a prospective shareholder needs to know and understand.
Profit margins and return on equity vary greatly from industry to industry, and a comparison with like companies will reveal how well the company of interest is doing versus its peers. There are certain specialized companies such as Master Limited Partnerships, Real Estate Investment Trusts, and Business Development Companies, which fall under a different set of regulations than the vast majority of corporations giving them tax free status and a requirement to distribute 90% of their income. In these unique operations, other metrics such as distributable cash flow, interest rate trends, and hedging may play an equal or more important role than current earnings in the evaluation process. If you are interested in these areas, once again, the internet is an excellent source of additional information.
DEBT and EQUITY
The RATIO of DEBT to EQUITY is a very important metric especially in industrial or manufacturing type companies. It is clearly better to have more equity than debt, therefore when equity is divided into debt in a healthy company the debt to equity ratio should normally be less than one.
ASSETS and LIABILITIES
Similar to debt and equity, it is logical that under ordinary circumstances that it is favorable to have more assets than liabilities. As a general rule you will want to see assets at least double liabilities. When you divide assets by liabilities it is called the CURRENT RATIO. And you should be looking for a current ratio of at least 2.
BOOK VALUE PER SHARE
Book value per share refers to the amount of equity each share holder has in the company determined by dividing the net value of the company (assets less liabilities) by the number of shares outstanding. Quite frequently successful companies’ share prices will significantly exceed book value due to the market’s perception that annual income is growing and sustainable. At times a good company may sell at or below book value. This is often an indication that the market is undervaluing the stock for one reason or another. A company that the market is misreading and is selling irrationally below book value can often be a buying opportunity. Different sectors have different typical book to share price ratios, and it is important to see how the share prices of other equities in the same field relate to book value as a comparison.
Who owns a stock, and what their buying and selling history is, can be very significant in determining whether or not an equity is a good candidate to pursue. Statistics on insider and institutional buying and selling are generated by law, and can be quite telling as to the future of a stock. Would you rather buy a stock where the INSIDERS (Officers and others in the know) own a significant share of the company and continues to accumulate, or a company where insiders are selling? Similarly, what does it tell you when large INSTITUTIONS are accumulating? What does it tell you when they are divesting?
Again, this information is published and available on most free financial websites or can be had for the asking from any broker. On the other side of the coin are the short sellers. When there is high SHORT INTEREST (shares are being borrowed and then sold with the hopes of buying them back at a lower price in order to give them back to the original owner) it means that there is a belief among the short sellers that the price of that equity will go down. The question to ask is, what do they know that you don’t, or if you want to buy, what do you know that they don’t? Short sellers tend to be professionals, and often are involved with large successful hedge funds. As a general rule when short interest is high, and growing, it is a time to be very wary when considering a purchase. Statistics on short interest, like those of insider and institutional ownership are published and available readily on the internet.
Every time you see the phrase, “Past performance is no guarantee of future results,” remember that while it is no guarantee it is probably the best indicator available. If you take the time to learn about prospective companies and understand how they operate, and then review their historical performance in light of the relatively few metrics listed above, you will be way ahead of the vast majority of investors. Remember, this information is readily available, and as you can see from the above is not complicated to evaluate. It does take a little time and effort, and only you can determine if that effort is worth while. There are always plenty of people out there more than happy to tell you what to buy. The only question that I suggest you ask yourself is: Who cares more about your money than you do?