Source: Flickr user Lendingmemo.com.
Investing can be hard, but there are some things you can do to make it easier. Following in the footsteps of great investors like George Soros and Warren Buffett is a good idea, but finding ideas on your own will mean doing a bit of research. That can seem a bit daunting, especially if you don't have a background in finance, or any idea where to start. With that in mind, here are three basic facts that every investor should know about a stock before making a decision to buy or sell.
1. Is revenue growing and why?
Businesses operate on a kind of life cycle. New companies grow their revenue very quickly, while big blue chip companies may see revenue growth that is more tepid. Other times, companies that are fast growers -- think Enron or Eastman Kodak -- become no-growers, and eventually go bankrupt.
Obviously, investors want to focus on companies where revenue is at least stable, and ideally, investors want to be involved in companies where revenue is growing. But don't stop there. Try to figure out why revenue is climbing, too.
Does the company have a new product? Did it make an acquisition that boosted sales? Did a competitor stumble? Discovering the answer to that question will tell you a lot about whether or not a company is worth investing in for the long haul.
For example, let's consider Apple (AAPL 0.64%). In the third quarter of 2014, the company's sales increased to $42.1 billion from $37.5 billion in the third quarter of 2013. What caused Apple's sales to grow? According to the company, sales of iPhones grew 26% and sales of Macs grew 18%. The company launched its next-generation iPhone, and Mac sales grew while the broader global PC market shrank. All in all, investors should feel pretty good about the quality of the company's sales growth.
2. Are profits climbing?
When it comes down to brass tacks, a company's ability to produce profit is the lifeblood of investor returns. Young companies often have to plow considerable revenue back into research and development, infrastructure, or employees, and that means that many emerging, high-growth stocks don't have much in the way of earnings to show for their revenue growth.
But that doesn't necessarily mean that investors should ignore all companies that don't generate a profit. After all, spending on R&D and hiring salespeople may weigh down profit in the short term, but could boost earnings considerably down the road.
Technology and biotechnology stocks are a great example. Developing cutting-edge software or medicine is costly, and that means that profit for these types of companies can be a bit elusive at first.
Regardless, if a company earns more profit this year than it did last year, it's a good sign that management is succeeding at either leveraging sales growth -- see point one above -- or cutting costs. In order to figure out the reason behind a company's profit growth, investors will need to do a bit of digging through a company's most recent earnings reports. Assuming that digging shows that the profit hasn't come via accounting gimmickry, the fact that a company is turning more revenue into profit means that it may have more opportunities to acquire competitors, develop new products, or return money to investors in the form of dividends or share repurchases, all of which can be shareholder friendly.
Turning our attention back to Apple, during the third quarter of 2014, the company reported a net profit of $8.5 billion, which was up from $7.5 billion in the third quarter of 2013. According to the company's third-quarter earnings report, that profit growth came thanks to cutting the company's cost of goods sold. As a result, Apple's gross profit margin improved to 38% in the quarter, up from 37% the year before. Because quarterly profit jumped by a billion dollars in the past year, and profit margin expanded, investors should feel pretty good about Apple's profit picture, too.
3. Is the balance sheet solid or not?
Discovering that a company's sales and profit are growing are great first steps, but it also helps to know whether or not a company can make good on its financial commitments if debtors come knocking. That's why investors should spend time considering the balance sheet.
The balance sheet will tell you how much cash, investments, and other assets the company owns, and how much debt and other liabilities the company owes. One quick way to evaluate the health of a balance sheet is to look at a company's current ratio.
The current ratio measures how financially liquid a company is by dividing cash and equivalents by short-term liabilities, like debt payments and taxes. A current ratio higher than one suggests that the company can meet its short-term obligations. The higher the current ratio, the better.
In addition to looking at the current ratio, investors will want to know how much long-term debt the company owes. The less debt on the books, the less a company will have to pay out in interest payments, and the more revenue that can drop to the bottom line.
In the case of Apple, the company is sitting on $25 billion in cash, and boasts a current ratio of 1.08. That suggests that investors don't need to be overly concerned with Apple's short-term financial situation. Additionally, although Apple carries a fair amount of long-term debt, a look at the balance sheet shows that the company has $130 billion in long-term investments, most of which is held overseas. That's far more than enough to pay off the $29 billion it has in long-term debt.
Just a start
Finding winning stocks begins with a basic idea, and ends with a decision to buy or sell that's rooted in sound analysis. There are many ways to uncover intriguing investment ideas, and a seemingly endless string of financial data and ratios that investors can use to back up their decisions. However, understanding the revenue and profit picture, and getting comfortable with the balance sheet, is a great, and essential, way to begin.
