Say you recently inherited money from a relative and have no clue where to invest in. You are interested in investments, especially in the stock market, so you read in the newspaper and books. But, you keep asking yourself, what is the best way to invest in the stock market? Look no further than the most successful investor in the world; Warren Buffett. For a man who has beaten the S&P 500 benchmark 39 out of the 47 years his company has been in business, Warren Buffett still sticks to the same simple guidelines when choosing stocks: valuing the business behind the stock with the purpose of buying good companies at cheap prices. Investors like Warren Buffett look at a company’s fundamentals like earnings, cash flow, and debt to figure this strict criteria. Like a bargain hunter, the value investor tries to find undervalued companies by determining its intrinsic value, and staying away from what is currently popular in the market at that time.
First things first, earnings drive a company’s stock price. Therefore, you must look at a company’s balance sheet and income statement in order to fully understand its financials. From that, you will know if the company whose stock you are buying is a good company or not.
All of this information is free to view publicly on sites such as Yahoo Finance.
There are three statements that show a company’s health: Balance Sheet, Income Statement, and Statement of Cash Flow. For now, we will take a look at the Balance Sheet and Income Statement.
Let’s take a look at its balance sheet:
Investors like Warren Buffett inspect a company’s balance sheet to see if it can weather the storm in bad times or good times.
In order to see if it can repay its debt and remain solvent, they look at its current assets. You can see the liquidity of the company from there. Things like cash, accounts receivables, and inventory. Assets are shown from most liquid to least on the balance sheet.
From the balance sheet we can see two measures of liquidity:
The Current ratio, which is current assets/current liabilities. The higher the number, the more “cash” it has on hand to pay off any short term liabilities. 2 is a good number to start.
The Acid Test ratio gives a clear view of a company’s cash position.
From there, Take a look at its long term assets found below current assets (real estate, factories, warehouses, equipment, and investments).
Also, check out Long Term Liabilities (debt, bank loans, bond issues) are liabilities growing faster than assets?
Book value, by subtracting all it owns with all that it owes, you will come up with its worth on paper. For investors like Warren Buffett, they look to buy stocks on sale, so that means buying companies at a discount. That way you have a margin of safety, even if the stocks goes down momentarily. You will still know that you bought it at a 50% discount, and there is room for it to grow.
Find out its Debt-to-Equity ratio (total debt/shareholder equity). This is an important measure, basically tells you the proportion of debt it has relative to what it owns. (A number higher than 1 means company is funded more by debt than equity). A company with too much debt is riskier than a company with less debt.
If everything looks good then look at its Income statement to see its earnings:
–Earnings, prices of most stocks is driven by earnings
–Growing earnings are good
-The Cost of Goods Sold, is the cost of the product or service of the company. This is subtracted from revenue to get your profit. Check to see if COGS is growing or shrinking relative to revenue. A way to do this is measure its profit margin relative to different years. A growing profit margin is very good.
–Earnings per Share (EPS) is a key driver for a stock prices. It’s basically your net income/shares outstanding.
-Look at the ROE or Return on Equity. Is it growing?
Using these figures, you want to see if there is a growing/shrinking trend year to year. Many analyst use a 3-5 year projection, as anything over 5 years is hard to predict. Since I am a big Apple fan and invest a large amount of my holdings in Apple, I will show you a general spreadsheet of its recent 3 year figures.
Last closing Price: $544.47 as of Friday March 2, 2012
If you want to know what the two ratios above mean, read my article about “Key Ratios When Evaluating Stocks”
(All numbers in thousands)
|Stated Profit margin||19.19%||21.48%||23.95%|
|Acid Test Ratio||2.58||1.79||1.42|
|Book Value per share||26.00||40.00||60.00|
From 2010 to 2011, Apple’s earnings almost doubled. It’s profit margin at in the 20% range is the highest in its industry and is growing. It has virtually no debt, and has a cash balance of 100 billion dollars. As you can probably see, Apple’s financials are rock solid. Also, if you can put a dollar value on brand, you can say that Apple has one of the most valuable brands of any company. Every time the company launches a product such as the ipad or iphone, there are long lines out the door, into the next block. People in china are selling kidneys and body organs to get an ipad. That is how attractive these products are to consumers.
With a P/E of 15, Apple (in my opinion) is still cheap. Apple only has 10% market share in the global computer industry, and if you factor in growth from its future product launches such as the ipad 3, iphone 5, and Apple TV, you should expect Apple to profit tremendously.
I am a big subscriber to value investing, the same method that has made Warren Buffett so successful. Since you have worked so hard to save your money, why not take the extra time and do the proper research on stocks before you invest it? Often times, people rush in the buying process on a hunch or a feeling about a company without the due diligence.