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Six Questions to Ask Before Buying a Stock

Here are six questions that every investor, whether looking for high-flying growth stocks or beaten-down value plays, should ask before buying. You can find the needed information on many financial sites.

1) Real Business?
What is your candidate’s main business? You probably know what Wal-Mart does, but what about ICON (ICLR) or Knoll (KNL)?

You can find out by checking the Description shown on MSN Money's Company Report (Fundamentals menu), which describes each company in enough detail to give you a feel for its business. For instance, ICON provides outsourced clinical trial services to pharmaceutical companies and Knoll makes office furniture.

How do you use that information? If you’re looking for growth stocks you might find ICON of interest. Value investors, however, knowing that the market ignores unglamorous industries, might consider Knoll a potential undervalued gem.

2) Real Revenues?
Although the market focuses on earnings at report time, in the end, earnings come from sales (revenues). Thus, annual revenues (Company Report) are an important selection factor.

Risk-averse investors should require at least $500 million in annual sales. Those more adventurous could go lower, but the risk meter goes off the chart when you get below $100 million.

You can't apply this criterion to banks and similar institutions because their income comes from interest earned, which doesn't show up in the revenue totals.

3) Really Profitable? 
For stocks, profitability means more than not losing money. Here’s why.

Consider two hypothetical companies, Company A and Company B. Both earned $10 million last year. However Company A’ shareholders only had to invest $30 million to turn that profit compared to $60 million for Company B. Thus, Company A’s investors realized twice the return of Company B for each invested dollar. 

Return on equity (ROE), the ratio of a company's 12-month net income to its shareholder equity (book value), is a widely used profitability gauge. You can see ROE in the Investment Returns section of the Key Ratios report (Fundamentals). Require a minimum 15% ROE and higher is better.

If you’re a growth investor, use the current number (top line). However, since value stocks may have recently stumbled, value investors should use the 5-year average ROE.

4) Making Real Cash?
Operating cash flow measures the amount of money that moved into, or out of, a firm's bank accounts attributable to its business operations.

Cash flow is a better profit measure than earnings because it's harder to finagle bank balances than numbers like depreciation schedules that figure into earnings. In fact, many companies that report positive earnings are actually losing money when you count the cash.

Use the annual cash flow statements (Financials) and require a positive number for “cash from operating activities.” While any positive number is okay, it's better if the operating cash flow exceeds the net income (top line) for the same period (be sure to use the annual statement, not the quarterly).

5) Too Much Debt?
Many experts see higher interest rates coming. Should that happen, the resulting higher carrying costs would cut into earnings of firms carrying high debt loads.

The financial leverage ratio (total assets divided by shareholders' equity) is an all-purpose debt gauge. A company with no debt would have a financial leverage ratio of one, and the higher the ratio, the more debt. The average leverage ratio for companies making up the S&P 500 index is 3.8. Avoid firms with leverage ratios above 4.0 and lower is better. Find the leverage ratio in the Key Ratios report (Financial Condition).

You can't apply debt measures to banks and other financial organizations. For them, borrowed cash is their inventory. Financial firms always carry high debt compared to other industries.

6) Sagging EPS Forecasts  
Analysts usually forecast earnings (EPS) for stocks that they follow. MSN Money displays consensus forecasts, which are the average forecasts from all analysts covering a stock, on its Consensus EPS Trend report (Earnings menu). MSN shows the current numbers as well as estimates going back as long as 90 days.

Positive changes in consensus forecasts almost always move share prices up, while falling forecasts usually crush share prices. What’s interesting is that consensus numbers often move in trends. That is, forecasts that have already moved up are likely to move higher, and vice versa.

Check the fiscal year estimates going back 90 days and compare the current estimate to the 90-day ago number (ignore one-cent changes).

Look for stocks with rising trends and avoid stocks with estimates going the other way.

Checking these six items will help you make better investing decisions, but they are just a start. Dig deeply and learn all you can. The more you know about your stocks, the better your results.

published 5/22/11

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