Researching a Company for Investment

Maybe you heard about a hot new company from a friend of a friend, or you saw a news segment featuring a promising new invention, or maybe you’ve been impressed with a familiar brand’s recent marketing campaign. You know there’s money to be made in investing, but how do you know if a company is really doing well and if it’s worth risking your hard-earned dollars? With a few point-and-clicks and some simple arithmetic, you can answer these questions for yourself.

Once you know what you’re looking for, researching companies can be very easy. Your first stop should be at the prospective company’s own Web site. As you study the site, ask yourself some key questions: What does the company do? How do they make money? Who are the current and potential customers? Is the demand for their products or services likely to grow in the long-term? Who is their competition? Do you like the “personality” of the company? At this point, if you’re turned off or otherwise unimpressed, you probably don’t want to invest there. On the other hand, if you’re liking the big picture, move in for a closer inspection.

In many cases, you won’t need to go much further than a click or two to get to the company’s latest annual or quarterly report. If the financials are not found on their Web site, you can contact their investor relations department directly and ask for a packet to be sent to you. You could also utilize the online database, Electronic Data Gathering, Analysis, and Retrieval system (EDGAR), maintained by the U.S. Securities and Exchange Commission, or visit your local library for information sources.

Once you find it, read the latest report from beginning to end. Some parts of the report may be boring or even confusing, but much of this information is valuable to a current or potential investor. For example, you will find out about the company’s most recent problems and how they were solved. You will also learn about potential challenges and, more important, how management plans to overcome them. You will start to develop a picture of the company’s self-analysis, management style, and overall health.

After digesting the narrative sections, find a calculator and a pencil and dive into the tables. Much of the company’s financial health can be found in three documents: the balance sheet, the income statement, and the cash flow statement. If you’re not familiar with financial documents, take some time to absorb the jargon and the figures. Don’t let the numbers intimidate you; they are there to inform you. Following are just a few of the key elements to examine, as well as some calculations to help you further scrutinize the numbers.

The balance sheet tells you how much money the company owns, owes, and has left over for the stockholders. Seeing a lot of liquid assets here tells you that the company can grow the business and pay down debts--good signs of a healthy company. Next, you want to look at the company’s short- and long-term financial obligations, or liabilities. Specifically, check to see if the current assets (the ones that could be quickly liquidated) are enough to pay off the current liabilities.

Regarding debt: many investors prefer to invest in growing companies that have little or no long-term debt, the theory being that today’s borrowing puts tomorrow’s opportunities at risk. A simple debt calculation, total assets divided by shareholders’ equity, gives you the financial leverage ratio. A leverage ratio of 1 means that the company has no debt; 9 indicates high debt. Many experts recommend that you avoid companies with leverage ratios above 5.

Next, check for low accounts receivable (AR). Although businesses typically negotiate payment arrangements, raise an eyebrow if a company is allowing more generous terms of payment. This indicates a softness in the demand of the company’s product. To determine AR using a quarterly report, for example, divide the sales figure by the accounts receivable figure. Then divide that number by 90 days. Ideally, a company will operate with less than 30 days of outstanding AR.

The income statement summarizes revenues and expenses for a fixed period of time. The first thing you want to see here is high revenue growth. This is an obvious indication that people want what the company is selling. Look for successful smaller companies to show double-digit growth from year to year whereas huge companies may show only modest gains.

Next, determine the gross profit by subtracting the cost of goods sold (COGS) from the total sales. (This figure may be spelled out for you in the document.) Divide the gross profit by revenues to get the gross profit margin. Compare this number with your company’s competitors to see who is benefiting by using the industry’s best practices, and also compare it to the company’s own previous years’ profit margins. If the company is becoming more efficient, and therefore more profitable, the margins will show increases.

For some industries, you can learn a lot from the research and development (R&D) figure. A high-tech company, for example, should be spending increasing amounts of resources on R&D. Divide the R&D figure by total revenue to get a percentage of sales. Look for this number to at least hold steady if not increase. If it decreases from year to year, the company is spending its money elsewhere--not a good sign for a business dependent on being the first and/or the best at developing an emerging technology.

For retail and manufacturing companies, inventory is a very important factor. Inventory turnover is found by dividing the cost of goods sold by average inventory. This indicates how long the company “sits” on the product before selling it. The higher the number, the more the stuff is moving out the door. Track this number from year to year to determine if the company is trending in the right direction. Again, for the sake of perspective, do the same calculation with a competitor’s figures to see if your company is performing better than its peers.

Last, the cash flow statement details (as you might expect) how cash flows in from the operations or from sales of stocks and bonds, and how it flows out to invest in growth. Most investors want to see that the company can operate the business with the cash on hand, meaning the company won’t need to finance in order to cover its spending. Look for a positive number (not one in brackets) on the “net cash provided by operating expenses” line.

Please keep in mind that investing methodologies vary. What might be considered “good” numbers for one business could be dreadful for another. As stated in a few of the previous examples, your time would be well-spent by comparing the financial data of similarly sized companies in the same industry. The clearer understanding of the marketplace will give you excellent perspective.

As you might expect, the suggestions here do not imply a no-fail approach to investing. Use your personal base of knowledge about various industries and your common sense as you continue to read about different investment theories. Beyond your initial research, keep current on the company’s progress. Read their press releases, pay attention to the news, and be aware of market changes that could affect the company. Above all, enjoy the empowerment (and the financial reward, of course) that comes from making decisions based on your own research.