Learning
to evaluate the financial statements before investing is beyond the scope of a
short article such as this, but we can give you some basics that will help you
begin to interpret financial statements and give meaning to the numbers.
Before we begin, just a
word of caution: stock picking is an easy way to lose your nest egg. Rather than
investing your hard-earned savings immediately into a bunch of stocks you pick
on your own—or worse, one stock—consider allocating just 10% of your total
investment portfolio to the stocks you pick yourself. Because you’ll want to
invest over time in at least a dozen different stocks to create the sort of
diversification you get in a mutual fund, you’ll want to have quite a nest egg
before you start picking your own stocks. Finally, don’t get caught trading.
Buy stocks and plan to hold them for a long time (measured in years, not
hours).
Now, let’s begin to look
at some basic financial concepts:
1. Income
Statement: The income statement or statement of operations is a financial
report that describes what the company generated in revenue over a period of
time (typically a year or a quarter) and the expenses associated with
generating that revenue. The profit is literally reported on the “bottom line.”
2. Balance
Sheet: The balance sheet is a report that shows what the company has and owes
along with the “equity” of the company. The assets are the things the company
has as of the balance sheet date and typically include cash, inventory, plant
and equipment and other assets. The liabilities or debts owed by the company
are also listed and may include accounts payable, accrued expenses, short and
long-term debt and other liabilities. The equity is the difference between the
assets and liabilities and is generally listed below the liabilities. The
equity is the accounting value of the stock held by the stockholders. Note that
the accounting value may not have much to do with the market value.
3. Financial
Ratios: There are a number of basic financial ratios that are often used to
help financial analysts and investors to compare one company to another to
determine which to buy and which to sell.
4. Price/Earnings
Ratio: Commonly called the P/E ratio, the price refers to the stock price and
the earnings is a reference to the profit per share (the latter being simply
the total profits of the company divided by the total number of shares
outstanding). So a stock with a price of $20 and earnings of $1 per share would
be said to have a P/E ratio of 20/1 or simply 2The average P/E of stocks in the
market varies widely depending on the economic cycle. The higher the number,
the more expensive the stock is perceived to be. Fans of Apple commonly comment
about how cheap the stock is despite a price well above $500 because the P/E
ratio is lower than some other companies in related industries.
5. Debt
to Equity: The debt to equity ratio is a comparison of the total liabilities of
the company to its total equity. Banks, which are highly regulated and
explicitly backed by Federal Deposit Insurance have very high ratios of debt to
equity. Many high margin, technology businesses with virtually no debt have
very low ratios of debt to equity. By comparing one company’s debt to equity
ratio to other companies in the same industry, you can get a sense of the
health of the company.
6. Profit
Margin: The profit margin is equal to the net profit of the company divided by
its total sales or revenue, yielding an answer that is usually quoted as a
percentage. Margins vary greatly from one industry to another and from one
point in an economic cycle to another. Comparing a company’s profit margin to
its past profit margin and to other companies in the industry will help you
understand more about the performance of a company.
There are countless
sources of this information on the internet. Most stock brokerages that have
online trading platforms also provide this kind of information in easy to use
formats. In fact, they provide much, much more. You can read about companies
that interest you to your heart’s content. One independent site that is popular
is MSN Money (on-msn.com/eJ05mD).
Keep in mind that
understanding how to read and understand financial statements is essential, but
it is only a part of learning to pick stocks.
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